Will the stock market hold the line? or do we keep hedging risk? and opportunity for high income yield

The U.S. stock indexes declined -6.84% for the large-cap S&500, -11% for mid caps, and about -19% for small-cap stocks mostly in the single month of May.

asymmetric risk reward stock market

Since June 1st, however, these same stock indexes have started to trend back up.

stock market asymmetry

Over the past 3 months, momentum has turned negative for the stock indexes.

momnetum stocks 3 month

My strategy was to hedge off some of this downside risk. I then removed my hedges for a profit. It doesn’t always work out that way. A hedge position isn’t necessarily intended to be profitable through the entry and exit, but instead, the objective is to hedge off some of the downsides of long positions. Sometimes I hold them too long and lose their gains, other times I exit and realize a profit, and then there are times I exit them too soon with a profit but miss an even large profit. It ain’t perfect, nor does it need to be, and I’m okay with it.

My stock market observation yesterday, which I shared on Twitter, was:

This double bottom could be a likely short-term low if the holds the line… my guess is it’s more likely than not. If it breaks down further from here, though, it probably gets ugly like when it didn’t hold last December…

SPY $SPY buy signal countertrend trend following

So far, so good… as marked with a simple trend line.

SPY INVESTMENT MANAGER TACTICALA week ago the AAII Sentiment Survey showed an unusually high level of Pessimism and optimism at an unusually low level… signals to stalk the market for good risk/reward setups on the buy side.

behavioral finance economics investor sentmiment advisor

I exited my hedges a few days ago and increase my exposure to stocks. However, I did this at the same time my momentum and systematic trend following systems shifted from stocks to bonds or cash. So, my entries are based on signals from my countertrend and high-income yield systems. As prices fall in high yielding ETFs, their dividend yield increases.

Global X SuperDividend™ US ETF (DIV) is an interesting example. This is not investment advice for anyone to buy this ETF as I only provide advice and portfolio management to clients via an executed contract. It is useless to know what I would buy if you don’t know how much I would buy and when I would sell. With that said, the chart of Global X SuperDividend™ US ETF (DIV) shows as the price (blue line) declined to a double bottom, the dividend yield has increased to 7.6%. So, if I entered it here, it would be expected to yield 7.6% going forward. I am only using this for informational purposes, so I’m not including all the variables and risks it may not which can be found here.

The point is, you can see how as price falls in a high yielding asset, it’s yield rises.

Global X SuperDividend™ US ETF (DIV)

I have recently made my ASYMMETRY® High Income Yield Portfolio available to clients who seek high income from their portfolio and are willing to accept fluctuation in the balance. Up until now, I had been testing this strategy with my own capital. The portfolio focuses on asymmetric risk/reward opportunities for high-income yield and also adds an asymmetric hedging system to help with downside risk management. For more information on the strategy, contact me.

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

Mike Shell and Shell Capital Management, LLC is a registered investment advisor and provides investment advice and portfolio management exclusively to clients with a signed and executed investment management agreement. 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. All information provided is 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. Use of this website is subject to its terms and conditions.

Stock market reaching an interesting point but I hedged some risk a week ago

Stock market indexes are reaching a point they should find some buying interest if it exists. We’ll soon find out if they can hold the line, or see more selling pressure…

stock market asymmetry

My short term momentum indicators are reaching oversold at the same time the S&P 500 is testing the support area in green above as well as the 200 day moving average.

At the same time, the Long Term Treasury ETF is pushing on its upper band and becoming more likely to reverse back down within its average range. I sold a position for a small profit in TLT that was short term hedge.

TLT ASYMMETRY HEDGE $TLT ASYMMETRIC

My other hedges, which are much more asymmetric than TLT, remain in place to hedge off some market risk until the selling pressure seems to be drying up. My hedging isn’t necessarily intended to result in a profit if the stock market falls, but instead of offset losses in other positions we want to continue to hold. Although sometimes the payoff in the hedge is large enough I realize the profit while it’s there. However, if I took profits too soon every time we wouldn’t have the exposure for hedging purposes in larger waterfall declines. At this point, we have open profits in our remaining hedges.

We’ll 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.

Mike Shell and Shell Capital Management, LLC is a registered investment advisor and provides investment advice and portfolio management exclusively to clients with a signed and executed investment management agreement. 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. All information provided is 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. Use of this website is subject to its terms and conditions.

 

The normal noise of the market?

We shouldn’t be surprised to see stock prices pull back closer to their average true range in the days ahead. Such a pullback or stall would be normal.

Below I highlight the strong momentum Technology sector XLK ETF as an example of stock prices in some sectors finally reaching their prior highs. In addition to the price trend reaching a point of potential overhead resistance at the prior high, we observe this trend is also outside the upper volatility band of average true range.

TECH SECTOR MOMENTUM XLK $XLK $IYW

Most of the time, we should expect to see a price trend stay within this range. If a price trend breaks out of the range higher or lower, it can be evidence of a trend change. In this case, the short term trend has been up since January, the intermediate trend has been sideways, non-trending and volatile since last September. Sine the short term trend has been an uptrend since January, I view the upside breakout above the volatility band a signal the trend may be more likely to pull back within the channel range.

The broad stock market S&P 500 index ETF SPY doesn’t look a lot different than the Technology sector, except it’s about -2% away from reaching its September 2018 high.

stock market SPY $SPY

The bottom line is, looking at the directional price trends they are up in the short term but reaching a point they could see some resistance from the prior highs. At the same time, my momentum systems suggest the trends are reaching an overbought level and the price and expanded outside their average true range channel.

A small short-term pullback in stock prices from here would be within the range I consider normal noise of the market.

 

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

Mike Shell and Shell Capital Management, LLC is a registered investment advisor and provides investment advice and portfolio management exclusively to clients with a signed and executed investment management agreement. 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. All information provided is 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. Use of this website is subject to its terms and conditions.

Giddy up…

As expected, the U.S. stock market declined briefly, then found enough buying enthusiasm to drive prices to a new breakout above the March high.

As I concluded in Strong stock market momentum was accompanied by broad participation:

“…though we shouldn’t be surprised to see short term weakness, we could suppose the longer term trend still has room to run.”

As we see in the chart below, while the U.S. stock market is trending with absolute momentum, the strongest relative momentum has been in other countries around the globe.

global macro asymmetric risk reward .jpg

Though my short term momentum systems signaled weeks ago the current uptrend may become exhausted and it did, the reversal back up and continuation since then appears bullish.

At this point, it appears some global stock markets are in uptrends and may have more room to run. For asymmetric risk/reward, I cut my losses short and let the winners run on.

Giddy up…

 

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

Mike Shell and Shell Capital Management, LLC is a registered investment advisor and provides investment advice and portfolio management exclusively to clients with a signed and executed investment management agreement. 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. All information provided is 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. Use of this website is subject to its terms and conditions.

What has changed? Global trends, volatility expansion and contraction, plus some rising interest rates

My focus is: What has changed? if I see no change in the direction of the trend of volatility, then we just go with the flow.

Realized (historical) and implied volatility (VIX) has settled down on the and it’s reflected in a Bollinger Bands contraction.

Periods of low volatility are often followed by periods of high volatility.

The empirical evidence is observed visually in this chart.

SPY SPX VOLATILITY MOMENTUM TREND

Volatility trends in cycles up and down, so they oscillate between high and low levels and can reach extreme highs and extreme lows. I believe volatility expansions are driven by indecision and vol contractions are driven by complacency decisiveness.

Small-cap stocks have been leading the way trending with momentum, but they’ve also declined a little more the past few days. Like the S&P 500 the Russell 2000 is showing contracting volatility after a big volatility expansion.

small cap momentum RUT IWM trend following system

Gold has been trending up gradually. I focus on the rate of change and momentum. However, recently Gold has declined sharp enough to indicate a short term volatility expansion.

gold gld $GLD

Emerging Markets has less of a rate of change than the higher momentum U.S. stocks, but volatility is also contracted.

EMERGING MARKETS TREND MOMENTUM

After a killer uptrend and momentum expansion last 2018 when stocks were falling, the Long Term Treasury ETF (TLT) has settled down into a non-trending period. It’s dropped below the volatility band, so maybe it will reverse up again. TLT is an example of a non-trending low vol condition, so we’ll expect a breakout from this range at some point.

TLT LONG TERM TREASURY HEDGE ASYMMETRIC RISK REWARD

Wanna see an example of an uptrend with low volatility? ETFs like SHV is a short-term  U.S. Treasury bond ETF with remaining maturities between one month and one year. It’s smooth, but with low risk, comes low potential reward. However, it’s a good example of a defensive position when it’s time for Risk-Off. It’s also probably a competitor to bank CDs and money markets.

SHV SHORT TREASURIES TREND VOLATITLIY MOMENTUM YIELD

Before you get too excited, here is the growth of $10,000 invested in the iShares Short Treasury Bond ETF (SHV) 10 years ago! With interest rates so low driving down the yield, it only grew to $10,380 because the interest rate was so low. 

shv

The good news for low-risk savers who invested their money in Treasury Bonds, their interest rates are trending up, so the yield is increased to nearly 2%.

Yield on Short-Term U.S. Treasury ETFs
That’s also good news for active risk managers like myself who increase and decrease exposure to the possibility of loss. Now, when I shift to defense and rotate from stocks to safer cash-like investments, we’ll actually earn some yield as wait for trends to improve. As you can see in the charts above, any defensive exposure intended to avoid risk temporarily didn’t earn the yield the past decade we did before. Unless we used higher yielding riskier positions for defense, it reduced our total return the past decade so look forward to getting that edge back.

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

Mike Shell and Shell Capital Management, LLC is a registered investment advisor and provides investment advice and portfolio management exclusively to clients with a signed and executed investment management agreement. 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. All information provided is 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. Use of this website is subject to its terms and conditions.

Welcome to March! A review of global asset allocation and global markets

In the first two months of 2019 global asset allocation has gained 4% to 8.6%. I use the iShares Core Global Allocation ETFs as a proxy instead of indexes since the ETFs are real world performance including costs. The four different allocations below represent different exposure to global stocks vs. bonds.

global asset allocation ETF ETFs asymmetric risk reward .jpg

I’m not advising anyone to buy or sell these ETFs, but instead using them as an example for what a broadly diversified global asset allocation portfolio looks like. Most financial advisors build some type of global asset allocation for their clients and try to match it with their risk tolerance. The more aggressive clients get more stocks and the most conservative clients get more bonds. Of course, this is just asset allocation, so the allocations are mostly fixed and do not change based on market risk/reward. This is very different than what I do, which is focus on asymmetric risk/reward by increasing and decreasing exposure to risk/reward based on my calculations of risk levels and the potential for reward. So, my system is global, but it’s tactical rotation rather than fixed allocation.

The iShares Core Allocation Funds track the S&P Target Risk Indexes. So, BlackRock is the portfolio manager managing the ETF and they are tracking S&P Target Risk Indexes. Here is their description:

S&P Dow Jones Indices’ Target Risk series comprises multi-asset class indices that correspond to a particular risk level. Each index is fully investable, with varying levels of exposure to equities and fixed income and are intended to represent stock and bond allocations across a risk spectrum from conservative to aggressive.

In other words, they each provide varying allocations to bonds and stocks. The Conservative model is more bonds, the Aggressive model is more stocks.

S&P Target Risk Conservative Index. The index seeks to emphasize exposure to fixed income, in order to produce a current income stream and avoid excessive volatility of returns. Equities are included to protect long-term purchasing power.

S&P Target Risk Moderate Index. The index seeks to provide significant exposure to fixed income, while also providing increased opportunity for capital growth through equities.

S&P Target Risk Growth Index. The index seeks to provide increased exposure to equities, while also using some fixed income exposure to dampen risk.

S&P Target Risk Aggressive Index. The index seeks to emphasize exposure to equities, maximizing opportunities for long-term capital accumulation. It may include small allocations in fixed income to enhance portfolio efficiency.

Below is an example of the S&P Target Risk Index allocations and the underlying ETFs they invest in. Notice their differences is 10% to 20% allocation between stocks and bonds.

Global Allocation Index Construction

These ETFs offer low-cost exposure to global asset allocation with varying levels of “risk,” which really means varying levels of allocations to bonds. I say they are “low-cost” because these ETFs only charge 0.25% including the ETFs they are invested in. Most financial advisors probably charge 1% for similar global asset allocation, not including trade commissions and the ETF or fund fees they invest in. Even the lowest fee advisors charge at least 0.25% plus the trade commissions and the fund fees they invest in. With these ETFs, investors who want long-only exposure all the time to global stock and bond market risk/return, they can get it in one low-cost ETF. However, they do come with the risks of being fully invested, all the time. These ETFs do not provide any absolute risk management.

As an unconstrained, go-anywhere, absolute return manager who does apply active risk management, I’m unconstrained from a fixed benchmark, so I don’t intend to track or “beat” a benchmark. I operate with the limitations of a fixed benchmark. My objective is to create as much total return I can within a given amount of downside risk so investors don’t tap out trying to achieve it. It doesn’t matter how much the return is if inveestors tap out during drawdowns before it’s achieved. However, I consider global asset allocation that “base rate.” If I didn’t think I could create better asymmetric risk/reward than these ETFs I wouldn’t bother doing what I do. I would just be passive and take the beatings in bear markets. If we can’t tolerate the beatings, we would invest in the more conservative ETF. I intend to create ASYMMETRY® and win by not losing, and that necessarily requires robust risk management systems and tactics.

Now that we know what they are, below are their total returns including dividends looking back over time. (To see the full history in the prospectus click: iShares)

In the chart below, we see the global asset allocation ETFs are attempting to get back to their September 2018 high. While the S&P 500 stock index is still down about -4% from its September 2018 high, the bonds in these ETFs helped reduce their drawdowns, so they have also recovered their losses better.

global tactical asset allocation asymmetric risk reward

To be sure, below are the drawdowns. The iShares Core Conservative ETF is only 30% stocks and 70% bonds, so it had a smaller drawdown and has recovered from it already. I added the S&P 500 in this chart with is 100% stocks to show how during this correction, the exposure to bonds helped offset losses in stocks. Diversification does not guarantee a profit or protect against a loss in a declining market. Sometimes diversification and even the broadest global asset allocation fails like it did in 2008.

GLOBAL TACTICAL ASSET ALLOCATION ASYMMETRIC RISK REWARD DRAWDOWN

We can look inside the ETF to see their exposures. Below we see the iShares Core Moderate ETF which is 60% stocks and 40% bonds largest holding is the iShares Core Total USD Bond Market ETF (IUSB) at 50% of the fund.

iShares Core Moderate Allocation ETF

Below is the 1-year total return chart including dividends for its largest holding. It has gained a total return of 2.9% the past year. All of the gains were this year.

iShares Core Total USD Bond Market ETF (IUSB)

Next, I added the other two largest holdings iShares Core S&P 500 ETF (IVV) and iShares Core MSCI International Developed Markets ETF (IDEV). The weakness was worse in international stocks. 

GLOBAL ASSEST ALLOCATION ADVISORS TACTICAL

No total return chart is complete without also looking at its drawdowns. The combination of the total return chart and the drawdown is what I call the ASYMMETRY® Ratio. The ASYMMETRY® Ratio is the total return divided by the risk it took to achieve it. I prefer more total return, less downside drawdown.

global tactical asset allocation drawdown risk management

The point is, global stocks and bonds have recovered much of the losses. As we would expect so has global asset allocation. The only issue now is the short term risk has become elevated by my measures, so we’ll see how the next few weeks unfold.

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

Mike Shell and Shell Capital Management, LLC is a registered investment advisor and provides investment advice and portfolio management exclusively to clients with a signed and executed investment management agreement. 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. All information provided is 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. Use of this website is subject to its terms and conditions.

Strong stock market momentum was accompanied by broad participation

Not only has the broad stock market indexes like the S&P 500 advanced sharply with great momentum since late December 2018, but its breadth has also been impressive.

The percent of stocks trading above their 50 day moving averages shows about 92% of stocks are in short term uptrends. This advance not only confirmed the price trend momentum but suggests participation has been broad. More stocks are above their 50-day moving averages that late 2017.

percent of stocks above the 50 day moving average trend following asymmetric risk reward

The downside is we are necessarily observing only the past and the past doesn’t assure future performance. In fact, once 92% of stocks are already in shorter-term uptrends, we can start to wonder at what point the buying enthusiasm is exhausted. That is, indicators like this may be observed for signs of an inflection point.

percent of stocks above 200 day moving average trend following

However, the percent of stocks above their 200 day moving averages is at 63%. So applying that same line of thinking, though we shouldn’t be surprised to see short term weakness, we could suppose the longer term trend still has room to run.

We’ll see…

 

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

Mike Shell and Shell Capital Management, LLC is a registered investment advisor and provides investment advice and portfolio management exclusively to clients with a signed and executed investment management agreement. 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. All information provided is 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. Use of this website is subject to its terms and conditions.

U.S. Stock Market Update

Last week in What’s going to happen next for the U.S. stock market? I shared an observation the U.S. stock index had reached a point I expect to see at least a stall. So far, that’s mostly what we’ve seen the last week.

stock market momentum

The stock index has reached a point that a stall or reversal is even more possible now. As we see in the above chart, the uptrend has been strong and sharp. Volatility, how wide the price spreads out, has also narrowed. After prices trend up, volatility tends to shift from expansion to contraction and that’s about when a trend becomes more likely to change, at least temporarily.

My momentum systems also suggest the velocity of the uptrend has reached a point the short term trend is becoming more susceptible to stall or reverse.

Otherwise, the short term trend has been strong and rising. The longer-term trend as seen in the chart is defined as sideways using a smoothing trend-following indicator like the 200-day moving average. Notice the blue line is virtually sideways and barely adapted to the -20% drawdown. The S&P 500 is now above its average of the past 200 days. However, notice it crossed above it three times October through December before reversing down sharply.

So, I define the current S&P 500 trend and condition as follows:

From this starting point, I expect the asymmetric risk/reward from here may be limited. I’m glad we participated in this recent trend, but we are positioned more carefully short-term at this stage.

However, if the current short term uptrend continues with high momentum, it would be very bullish for the longer term and may negate the likelihood that this could be the end of a decade long bull market. If this is an aged bull market ending, we’ll see swings up and down as it shifts. If the nearly -20% decline was enough, we’ll see new highs in the weeks or months ahead.

We’ll see.

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

Mike Shell and Shell Capital Management, LLC provides investment advice and portfolio management solely to clients with a signed and executed agreement. 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.

Stock Market Update

After gaining over 6% since the low on Christmas Eve, the S&P 500 declined -2.45% today. We can expect a wider range of prices in a volatility expansion after a -20% decline.

spx january 3 2019

I say it’s a volatility expansion because implied volatility is relatively elevated at 25.45, implying a 25% range of prices is implied by options prices on the S&P 500 stocks.

vix volatility expansion

Looking over its full history, we’ve seen the VIX trend higher, but it’s relatively elevated. Its long-term average is about 20. But, for mean reversing indicators like the VIX, the average doesn’t mean much since it doesn’t stay there.

vix long term history

Another way I define a volatility expansion is realized volatility. The VIX is expected volatility implied by options prices, realized volatility is actual historical volatility. In the chart below I added an average true range over the past 14 days above the S&P 500 stock index price trend. We can see how volatility expanded as the price trend fell. Prices tend to spread out in a wider range in a downtrend. We can see this in the chart. There was a regime change from a low volatility uptrend to a downtrend with volatility expansion.

atr volatilty expansion realized vol asymmetric risk reward

The CBOE Put Call Ratios spiked up today. Zooming in to a 30 day period, we see the Index Put Call Ratio is about where it was at the lows in December. I believe the Index Put Call Ratio is a better indication of extremes in fear of lower prices because index options are mostly traded by professionals and used for hedging. The Equity Put Call Ratio is options on individual stocks and more non-professionals and tends to be more speculative. I explained it in Investor Sentiment into the New Year 2019. 

put call ratio january 2019

To get a longer view below is the past five years of the Put Call Ratios. They’ve been higher in 2015, but are clearly at elevated levels. It indicates the put volume on index options is 155% more than call volume, which suggests hedging or speculative bets the index will decline.

put call ratio peaks past years 2018

Prices decline until the selling pressure is exhausted. Selling pressure is exhausted after those who want to sell have sold, which pushes prices down to a low enough point to attract buyers. To get an indication of when prices have trended down far enough to exhaust sellers and attract buyers, I look at the price trend itself as well as extremes investor sentiment and breadth. Below is the percent of stocks in the S&P 500 below their 200 day moving average. The percent of stocks above their 200 day moving average reversed back down… only 14% are in a positive uptrend. There are currently 505 stocks in the S&P 500. Of the 18 that are above their 50 day moving average, two are because they are being bought out Celgene CELG and Redhat RHT. Some of the others are kind of recession stocks like auto parts, discount store, and a gold stock: AZO ORLY DLTR NEM.

percent of stocks above 200 day moving average $spx $spy spx

The percent of S&P 500 stocks above their 50 day moving average reverses back down… only 3% are in an uptrend…

percent of stocks above 50 day how to use it spx

The stock market is approaching oversold levels again but may get more oversold before reversing back up.

One advantage of falling stock prices is as price falls, the dividend yield rises from that new price. This is not a recommendation to buy or sell any security, but below is the price trend and dividend yield the Global X SuperDividend® ETF (SDIV). It invests in 100 of the highest dividend yielding equity securities in the world. We can observe as the price trends down, the dividend yield trends up. That is, if we buy high yielding assets at lower prices, the dividend payment is higher from that starting point assuming the companies keep paying their dividends. Below we can see how this ETF yield has increased to 9% as its price has fallen -35% off its high.

high yield income strategy sdiv dividend etfLike any investment, it isn’t risk-free. Investing always involves risk, including the possible loss of principal. 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 Fund’s performance. International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles, or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. The bottom line is; there is no free lunch. If we want the potential for return, we have to take risks.

If this is the early stage of a larger decline, it will unfold with many up and down swings along the way. It will get overbought/oversold over and over and sometimes stay that way longer. I shared it in An exhaustive stock market analysis… continued. 

Emotional undisciplined investors, traders, and portfolios managers will be destroyed in a volatility expansion. They’ll swing from the fear of missing out to the fear of losing money as the stock market swings up and down.

Self-discipline and emotional fortitude are essential to be an investment manager.

We’ll see how it all 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 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.

 

To Know Where You’re Going, Look at Where You’ve Been: The 2018 Year in Review

I write my observations of trends and market conditions every day, though I only share some of them on ASYMMETRY® Observations. The advantage of writing observations as we see them is we can go back and read what we observed in real time.

The best “year in review” is to reread these observations in the order they were written to see how global directional trends and volatility expansions and contractions unfolded in real time. Reviewing our actual observations removes the hindsight bias we have today, looking back with perfect hindsight of what happened only after the fact.

It’s one thing to think back and write about what you observed over the past year, it’s another to revisit what you observed as you saw it. It’s even another to review what you actually did in response to what you observed.

Mark Twain’s mother once said:

“I only wish Mark had spent more time making money rather than just writing about it.”

I don’t take the time to share every observation I have because I am no Mark Twain. I am fully committed to doing it, not just writing about it. Writing about observations of directional trends and volatility is secondary to making tactical trading decisions and active risk management for me. I see no use in observing markets and writing about it if I do nothing about it.

The first observation I shared this year was on January 18th. The topic may sound familiar today. From there, I observed conditions to suggested we could have been seeing the final stages of a bull market, a trend change to a non-trending indecisive period, and a volatility expansion. If you want to understand what in the world is going on, I encourage you to read these observations and think about how it all played out over the year.

JANUARY 2018

All Eyes are Now on the Potential Government Shutdown

In remembrance of euphoria: Whatever happened to Stuart and Mr. P?

FEBRUARY 2018

In the final stages of a bull market

Asset Class Returns are Driven by Sector Exposure

Stock Market Analysis of the S&P 500

Stock market indexes lost some buying enthusiasm for the day

The most important rule of trading is to play great defense, not great offense.

Selling pressure overcomes buying demand for the second day in U.S. stock market

February Global Market Trends

Selling pressure overwhelms buying demand for stocks for the third day in a row

Buying demand dominated selling pressure in the stock market

Asymmetric Volatility

MARCH 2018

Stock pickers market? Sector rotation with stocks for asymmetric reward to risk

Investment management can take many years of cycles and regimes to understand an edge.

Asymmetric force direction and size determines trend

Asymmetric force was with the buyers

My Introduction to Trend Following

When I apply different trend systems to ETFs

The enthusiasm to sell overwhelmed the desire to buy March 19, 2018

Apparently there was more enthusiasm to sell

What’s going to happen next?

What’s going to happen next? continued

APRIL 2018

Is this correction and volatility normal?

Global Market Trends

MAY 2018

Is the economy, stupid?

JUNE 2018

Growth Stocks have Stronger Momentum than Value in 2018

Sector Trends are Driving Equity Returns

Trend Analysis of the Stock Market

Trend of the International Stock Market

Interest Rate Trend and Rate Sensitive Sector Stocks

Expected Volatility Stays Elevated in 2018

Sector ETF Changes: Indexes aren’t so passive

Commodities are trending with better momentum than stocks

Investor sentiment gets more bearish

Is it a stock pickers market?

JULY 2018

2nd Quarter 2018 Global Investment Markets Review

Global Stock and Bond Market Trends 2Q 2018

Stock market investor optimism rises above historical average

Trend following applied to stocks

Asymmetry of Loss: Why Manage Risk?

Earnings season is tricky for momentum growth stocks

Front-running S&P 500 Resistance

The week in review shows some shifts

AUGUST 2018

Global Market ETF Trends

Global Market Trends, U.S. Dollar, Emerging Markets, Commodities, and Their Changing Correlations

The Big Picture Stock and Bond Market Valuation and Outlook

SEPTEMBER 2018

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

Emerging Markets Reached a Bear Market Level, or is it a Continuation of a Secular Bear Market?

What trends are driving emerging markets into a bear market?

VIX level shows market’s expectation of future volatility

Rising Interest Rate Impact on Real Estate and Home Construction

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

OCTOBER 2018

Stanley Druckenmiller on his use of Technical Analysis and Instinct

Here comes the volatility expansion

Intermarket trends change over the past two weeks

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

Divergence in Global Asset Allocation

The Stock Market Trend

U. S. Sector Trends

Observations of the stock market decline and volatility expansion

The stock market trends up with momentum

Observations of the stock market downtrend

NOVEMBER 2018

The stock market is swinging its way to an inflection point

Divergence in the Advance-Decline Line May be Bullish

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

Momentum stocks need to find some buying interest

Will the stock market hold the line?

The Death Cross on the S&P 500

DECEMBER 2018

Stock Market Observations

What’s going to happen next for the stock market?

Global asset allocation takes a beating in 2018

The stock market has reached a short-term extreme as investor sentiment indicates fear

An exhaustive analysis of the U.S. stock market

An exhaustive stock market analysis… continued

Keep in mind, even if I see what could be the final stages of a bull market unfold, it doesn’t mean I try to just exit near the stock market peak and sit in cash for years. For me, it isn’t a simple ON/OFF switch. The highlight of my performance history has probably been my execution through bear markets. I’ve historically operated through them by being a tactical risk manager/risk taker, which means I increase and decrease exposure to the possibility of risk/reward with an objective of asymmetric risk/reward. I can’t assure anyone I’ll do as well in the future as I’ve done in the past, but I do know I’m even better prepared now than I was then. Being as prepared as possible and well-honed on situational awareness is the best I can do.

I’m looking forward to sharing more observations as we enter 2019 as global market conditions appear to be setting up for some trends to avoid, some to participate in, and some interesting trends to write about. To follow along, enter your email address on the top right of this website and follow me on Twitter.

HAPPY NEW YEAR! 

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.

 

An exhaustive stock market analysis… continued

I guess An exhaustive analysis of the U.S. stock market wasn’t exhaustive enough, because I now have a few things to add.

First, since the financial news media, as well as social media like Twitter, is so bearish with all kinds of narratives about why the stock market is falling, I’ll go ahead and discuss it here. This observation will not be complete without first reading An exhaustive analysis of the U.S. stock market so you know where I am coming from. If you haven’t read it already, I would before continuing so you understand the full context.

It is the financial news media’s business to report new information. We all know that if they want to get people to tune in, the fastest way is to provide provocative and alarming headlines and commentary. So, we shouldn’t be surprised to see distressing news.

There are always many reasons for the stock market to trend up or down. It isn’t hard to write some narrative attempting to explain it. The reality is, there are all kinds of causes that create an effect. None of them alone drive price trends. Ultimately, what drives price trends is behavior and sentiment which drives supply and demand. Behavior and investor sentiment may be impacted by the news and what people decide to believe.

I often say “what you believe is true, for you” even if it isn’t actually true. A person’s beliefs could be completely wrong and could be scientifically disproven, but if they still believe it, it’s their truth, so it’s true – for them. So, whatever you choose to believe is going to be your truth, so I suggest weighing the evidence to determine the truth if you want it to be more accurate. In science, we can’t prove the truth to be true, we can only disprove it as untrue.

Let’s look at some truths that I believe to be true based on empirical observation of facts.

The biggest news headline is probably the government shutdown. There have been twenty U.S. government shutdowns over the budget since 1976 by both political parties. Half of the time it was followed by stock gains and half the time declines. The average result is -0.40% and the median is 0%. So, historically a government shutdown hasn’t seemed to drive prices. Below is the table. It is what it is.

What does the stock market do after government shut down

Yesterday evening Steven Mnuchin, the 77th Secretary of the Treasury, tweeted a note that he had called the nations six largest banks to confirm they have ample liquidy for consumer and business lending and other market operations. The words “Plunge Protection Team” started trending in social media. Much of the response has been negative, which seems odd to me.

Since when was doing “channel checks” not a good idea?

It seems not doing it would be imprudent…

There are many things going on all over the world all the time, so we can always find narratives to fit the price trend and believe it’s the driver. Narratives and news also seem to drive more emotional responses since people like to hear a story. I focus on the data, which is the price action. Whatever is driving the markets is reflected in the price trend. The price trend is the final arbiter. Nothing else matters.

The Morningstar table of index performance shows the 2018 total return of large, mid, small cap stocks along with growth, value, and blend.

STOCK MARKET INDEX RETURNS 2018

The most popular broad-based indexes like the S&P 500 and Dow Jones Industrial Average show 2018 is ending just the opposite of the way it started.

stock index performance return 2018

Let’s look at some price trends.

Yesterday I shared the Bullish Percent measures on the broad stock market indexes and each individual sector. We observed the percent of stocks in all sectors except for the Utility sector was already at historical lows after previous market declines. After today’s price action, we have some updated observations to explore.

The S&P 500 is in a bear market, commonly defined as a -20% decline from a prior price peak. What is most interesting is how fast it reached -20%.  In the chart below, I included the S&P 500 Total Return Index (including dividends), the S&P 500 Index price only, and the S&P 500 ETF (SPY). On a total return basis, the S&P 500 Total Return Index that includes no costs or fees didn’t quite close down -20% from its high, but the rest did. It’s close enough.

bear market 2018 October November December Crash

Though the stock indexes had declined -10% earlier this year, they had recovered to new highs by September and it appeared the primary uptrend would resume. Starting in October, the stock market declined again and attempted to recover twice in November. What came next was probably most shocking to those who follow market seasonality; the stock indexes are down over -15% in the month of December, which is historically one of the strongest months of the year. It seems this decline happening so fast and at the end of a calendar year is going to make it seem more significant.  Because it’s at year end it results in a “down year” instead of having time to recover during the normally seasonally strong period after October. The period from November to April historically has stronger stock market gains on average than the other months. Not this year.

The Utility sector reverses down to participation in the market decline. 

Yesterday I had highlighted the top range of the Bullish Percent chart in yellow to mark the high-risk zone above 70%. After today, the Utilities sector has declined below that range. Individual Utility stocks are now participating in the stock market decline.

Utilities Sector ETF XLU BULLISH PERCENT RELATIVE STRENGTH MOMENTUM

The Utilities sector ETF declined over -4% today and is now slightly down for the year.

Utilities Select Sector SPDR® ETF $XLU

During significant market declines, diversification sometimes isn’t the crutch it is promoted to be by most of the investment industry. Broad asset allocation and diversification do not assure a profit or protect against a loss in a declining market. In declining markets, we often see price trends cluster more as serial correlation. That is, prices begin to fall more just because they are falling. Investors sell because prices are falling. So, stocks, sectors, and markets can all become highly correlated to the downside. By the end of a market decline, all stocks, sectors, and markets are often participating.

The upside is, this panic selling is capitulation as the final weak holders stop resisting and begin to “sell everything!” We eventually see the selling dry up and buyers step in with enthusiasm at lower prices.

In the big picture, as I said in An exhaustive analysis of the U.S. stock market I guess we shouldn’t be surprised to see prices falling with greater velocity since this is an aged bull market at high valuations and the same Fed actions that probably drove it up are probably going to reverse it in a similar fashion. I started this year warning of complacency from the 2017 low volatility uptrend and the potential for a volatility expansion. I also pointed out during the stock market peak in September that volatility had contracted to a historically very low level in VIX shows the market’s expectation of future volatility. Specifically, on September 25th I wrote,

“Looking at the current level of 12 compared to history going back to its inception in 1993, we observe its level is indeed near its lowest historical low.”

I ended it with;

“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.”

Well, that has turned out to be an understatement I guess.

What’s more important is what I actually did. On August 23th as the stock market began to appear overbought on a short-term basis, I took partial profits on our leading momentum stock positions. In hindsight, it would have been better to sell them all. By September 26th (when I wrote the above) I had reduced our exposure to only around 30% stocks and the rest in Treasury bonds. It still didn’t turn out perfectly as the stocks we did hold declined, too, and in many cases even more than the stock indexes. As we entered October, I shared a new observation “Here comes the volatility expansion” as stock prices fell and volatility increased. As prices fell to lower and lower levels, I started adding more exposure. At this point, prices have broadly become more and more extremely “oversold” and sentiment has become more negative. This has been a hostile period for every strategy, but I’ve been here before.

By the way, I have been a tactical portfolio manager for over twenty years now. The highlight of my performance history has been the bear markets. I executed especially well in the October 2007 to March 2009 period when the S&P fell -56%. My worst peak to trough drawdown during that period was only -14.3% and I recovered from it about six months or so later. That was compared to a -56% drop in the stock index that took several years to recover. In fact, I did so well at a time when very few did that it was almost unbelievable, so I had my performance verified by a third party accountant. I have considered writing about it and sharing the commentaries I wrote during the period and the tactical decisions I made. Make no mistake, it wasn’t easy nor was it pleasant. I didn’t lose the money others did, so I was in a position of strength, but it was still a challenging time. What I will tell you is I entered and exited various positions about seven or eight times over that two year period. We never know in advance when the low is in, or when a trend will reverse back down. Buy and hold investors just take the beating, I entered and exited hoping the average gain exceeds the average losses. The swings are the challenge. It takes great discipline to do what needs to be done. Most people had very poor results, for me to create good results, I necessarily had to feel and do the opposite of most people. The market analysis I’m sharing here as observations aren’t necessarily the exact signals I used to enter and exit, but they are part of the indicators I monitored during the crash. Every trend is unique. We have no assurance my methods will do as well as in the past. But, the one thing I feel confident in is I’ve been here before. This ain’t my first rodeo. I know what I’m doing and I’m disciplined in my execution. That’s all I can do. I’m dealing with the certainty of uncertainty, so I can’t guarantee I’ll do as well the next time around, but I am better prepared now than I was then.

So bring it. Get some. I’m ready. 

Yesterday I shared the extreme levels of Bullish Percent indicators for the broad market and sectors as well as other indicators like the Put/Call Ratios. I want to add to these observations with more indicators reaching an extreme. I’ve not seen these extremes since 2008 and 2009.

The Nasdaq has declined the most which is no surprise since it’s mostly emerging companies and heavily weighted in Technology. Market conditions have pushed the number of Nasdaq stocks hitting new lows to over 1,100 as of last week. Since the total number of Nasdaq issues is about 3,200 that has caused the value, in percentage terms, to jump to over 30% of the total. As you can see, the last time this many Nasdaq stocks hit new lows was the October 2008 low and the March 2009 low. The current level has exceeded other corrections since then and even the “Tech Wreck” after 2000. At this point, it becomes a contrarian indicator.

NASDAQ NEW LOWS PERCENT OF INDEX

To no surprise, the same trend is true for NYSE stocks. As of last week, the percent of stocks listed on the New York Stock Exchange at new lows has reached the levels of past correction lows, but not as high as the 2008 period.

NYSE NEW LOWS PERCENT NYA INDEX

From here, I’ll share my observations of the relative strength and momentum of the sectors and stocks within them so we can see how oversold they have become. We already looked at the Bullish Percent of each sector yesterday, this is just more weight of the evidence.

First, I applied the Relative Strength Index to the S&P 500 daily chart. This RSI is only 14 days, so it’s a short-term momentum indicator that measures the magnitude of recent price changes to estimate overbought or oversold conditions. RSI oscillates between zero and 100, so it’s range bound and I consider it overbought above 70 and oversold below 30. Below we see the current level of 19 is very low over the past twenty years and is at or below the low level reached during past shorter-term market bottoms. However, we also see during prolonged bear markets like 2000 to 2003 and 2007 to 2009 it reached oversold conditions two to three times as the market cycles up and down to a lower low.

RSI SPX RELATIVE STRENGTH S&P 500 INDEX

Zooming out from the daily chart to the weekly chart, we see the extremes more clearly and this is one of them. On a weekly basis, this oversold indicator is as low as it’s been only at the low points of the last two major bear markets.

sS&P 500 RSI WEEKLY RELATIVE STRENGTH SPX

Zooming out one more time from the weekly to the monthly chart, we observe a monthly data point only highlights the most extreme lows. It’s the same data but ignores the intra-month data. On a monthly basis, the current measure isn’t as low as it reached at the bear market lows in March 2009 or October 2002. For it to reach that level, I expect the green area I highlighted in the price chart to be filled. In other words, this suggests to me if this is a big bear market, we could ultimately see the price trend decline to at least the 2015 high. It only takes about -10% to reach that level. However, as we saw in the shorter term readings, if history is a guide, it would most likely cycle back up before it would trend back down.

RSI S&P 500 MONTHLY RELATIVE STRENGTH INDEX SPX

You can probably see why I stress that longer-term price trends swing up and down as they unfold. Within a big move of 50%, we see swings around 10 – 20% along the way.

Let’s continue with this same concept to see how each sector looks. The broader indexes are made of the sectors, so if we want an idea of the internal condition of the broader market it is useful to look at each sector as I did yesterday with the Bullish Percent indexes.

Since we just had a -15% correction in August 2015 and January 2016, we’ll just focus on the daily RSI looking back four years to cover that period. Keep in mind, none of this is advice to buy or sell any of these sectors or markets. We only provide advice and investment management to clients with an executed investment management agreement. This observation is for informational and educational purposes only.

The Consumer Discretionary sector is as oversold as it’s been at historically low price points. A trend can always continue down more and stay down longer than expected, but by this measure, it has reached a point I expect to see a reversal up.

CONSUMER CYCLICAL SECTOR RELATIVE STRENGTH MOMENTUM RSI TREND

The price trend of Consumer Staples that is considered to be a defensive sector initially held up, but then the selling pressure got to it. It’s oversold as it’s been at historical lows.

consumer staples etf relative strength trend RSI XLP

The Energy sector has declined the most in 2018 and is oversold similar to prior price trend lows. We can see the indicator isn’t perfect as a falling trend sometimes reverses up temporarily, then trends back down to a lower low only to get oversold again. We’ll observe this same behavior at different times in each sector or market.

energy sector etf xle relative strength rsi momentum trend following buy signal.jpg

The Financial sector is deeply oversold to the point it has reached at prior lows. Any market could always crash down more, but Financials have reached a point we should expect to see at least a temporary reversal up.

FINANCIAL SECTOR ETF XLE IYF RELATIVE STREGTH MOMENTUM RSI

Healthcare is a sector that isn’t expected to be impacted by the economy, but it has participated in the downtrend. It’s also reached the oversold point today. You can see what happened historically after it reached this level. If history is a guide, we should watch for a reversal.

XLV HEALTH CARE ETF RSI MOMENTUM RELATIVE STRENGTH

The Industrial sector is trending down but has now reached a point we could see a reversal back up.

XLI INDUSTRIAL SECTOR ETF MOMENTUM RSI

Clearly, the market decline has been broad as every sector has participated. The Materials sector reached the oversold level today.

XLB BASIC MATERIALS SECTOR ETF RSI MOMENTUM RELATIVE STRENGTH

Real Estate has not been spared during the selloff. It has now reached an oversold level normally seen at lows, but historically it’s cycled up and down a few times before reversing up meaningfully. That can be the case for any of them.

XLRE REAL ESTATE ETF IYR MOMENTUM TREND FOLLOWING RSI

The Technology sector had been one of the best-looking uptrends the past few years. It’s now oversold after today’s action.

TECHNOLOGY ETF XLK IYR MOMENTUM RSI RELATIVE STRENGTH ASYMMETRIC RISK REWARD

Up until today, the Utility sector was the lone survivor, but it was one of todays biggest losers. It’s falling so sharply so fast it’s now oversold with the other sectors.

XLU IDU UTILITIES UTILITY SECTOR ETF ETFS MOMENTUM RSI

After prices have declined, I look for indications that selling pressure may be getting more exhausted and driving prices to a low enough point to attract buying demand. That’s what it takes to reverse the trend.

I’ve been here before. I’ve executed through these hostile conditions as a tactical operator. The more hostile it gets, the more focused in the zone I get. After the stock market has already declined, I start looking for this kind of panic selling and extreme levels for a countertrend. We’re seeing those levels now. Sure, it could get worse, but we have reached a point that lower prices are more and more likely to result in a reversal back up.

I’m just going to do what I do.

Have a Merry Christmas!

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.

 

An exhaustive analysis of the U.S. stock market

It’s a big task for me to use the word exhaustive when it comes to stock market analysis. Exhaustive is examining, including, or considering all elements or aspects; fully comprehensive. There is no way to consider all elements, but we can focus on how the price trends are actually trending and the behavior and sentiment that is driving the trend.

Many years ago a friend of mine once tried to debate me about what trend following is or is not. He argued that trend following is all lagging moving averages or breakouts. The more we discussed it, the more we both realized that isn’t true. What made us realize it was when I said:

A skillful trend follower wants to catch a trend early in its stage and capitalize on it until it ends.

That’s hard to argue against. Who would rather enter a trend later in its stage? Who wants to catch less of the trend? My point is: we should want to capture as much of a trend as possible and for me, that necessarily means I want to not only determine the direction of a trend but also observe when trends are likely to change direction.

I want to share this with you so you know where I’m coming from. My objective is all about ASYMMETRY®. For me, it’s all about asymmetric risk/reward. Asymmetric risk/reward is an expectation of average gains larger than average losses. It could be as simple as risking a loss of 10% for the potential to earn a gain of 20%. That’s an asymmetric payoff. If I did that with just a 50% probability, I would earn 5% on average. How much total return we would achieve over time would be controlled by how much capital I risk in each position. How much I risk in each position across the portfolio dictates my portfolio drawdown. The portfolio drawdowns relative to total return since inception creates an asymmetric risk/reward profile. So, everything I do involves ASYMMETRY® and that’s why it’s my trademark. As you read my observations you can probably see how I’m looking for exposure at lower risk levels and less exposure at higher risk levels and that can be counterintuitive. It can certainly go against investor sentiment and emotions at times.

Every decision we make is in the present moment. We can do nothing in the past. We can do nothing in the future. The only time we can do something is now, or not.

To get an understanding of an asymmetric risk/reward let’s look at an idealized situation. The chart below, unnamed because it doesn’t matter, is a price trend that gained over 100%. If your objective is an asymmetric payoff and you have perfect hindsight, what would be your best entry point?

asymmetric risk reward investment

Clearly, the price is trending from the lower left to the upper right, so the answer is the lowest price possible. As I said, in the real world we don’t know in advance the trend will continue, so we have to be willing to place our bet and let it unfold. When I enter a trend, I determine how much capital I’ll risk to see if it becomes an asymmetric payoff. If we were looking at the trend in 2016 with perfect hindsight, where would be the very best entry? Of course if would be the -15% dips in 2015 and 2016. The trouble is, as the price is falling sharply, it never seems there will be a catalyst to make the market trend back up. The news is always bad. Investor sentiment is very bearish. The sky is falling and all people want to do is duck for cover.

After trends have moved, I find it more productive to look for a change of trend.

After price trends up, I start looking for signs of a potential countertrend back down.

After prices have fallen, I start looking for signs of a potential countertrend back up.

What I do as a tactical portfolio manager is systematic rules-based. Although, it isn’t so mechanical that my computers are doing it all and executing trades. I am Man + Machine, not Machine – Man. I make no bones about it. I ultimately make tactical decisions that are informed by all of the proprietary systems I’ve developed over the past two decades. Some of my systems are more automated than others, but ultimately I am the portfolio manager.

So, when I share market analysis observations, this is something different than specific trading signals to enter and exit. Market analysis is something I do to gain insights from my observations.

Observations are the action or process of observing something carefully in order to gain information.

Insights are the capacity to gain an accurate and deep intuitive understanding of something.

Observations are “what is going on” and insights are “understanding what is going on.”

I can share my observations of what is going on, but I can’t necessarily give you the insight to understand it. Understanding is up to you. To gain an accurate and deep intuitive understanding of something you have to study it closely.

So, you can probably see why I believe it’s useful to do market analysis to get an understanding of the probabilities and possibilities. I do it by looking at the current price trend and where it’s been and more likely to go next.

Here we go.

I said this is going to be exhaustive, so I’m going to share my top down macro view of the U.S. stock market. I also do this for International stock markets, bonds, commodities, etc. but this is going to be focused on the U.S. stock market. However, I may throw in some relative comparisons of other markets to make a point. The top-down macro view is going to be in this order;

  1. Broad stock market index price trends and breadth
  2. Sectors within the stock market price trends and breadth
  3. Stocks within those sectors price trends and momentum

THE BIG PICTURE

The big picture is the overall long-term secular situation. In April I presented my big picture observations to a group of advisors. The two things I shared are:

  1. This is the longest bull market in history. At 9 years old, it’s very aged. The average length of a bull market is 4 to 5 years. Twice the average is aged by any measure.
  2. The Shiller PE Ratio was the second highest, ever. Only the 1999 bubble was higher. When the stock market is trading so expensive, we have to be prepared for the trend to reverse the other direction.

Below is a 20-year monthly chart of the S&P 500. I added the green highlight to show the current price is only -35% from the October 2007 high eleven years ago. Losses are asymmetric as they compound exponentially. Losses erode gains asymmetrically. For example, the price gain from the 2007 high to the current price is 56%, but it only takes -35% to decline back to that point. You may also consider the stock index is only 56% higher than its 2000 peak eighteen years ago.

stock market secular trend

In The REAL Length of the Average Bull Market I wrote: “Whether you believe the average bull market lasts 39 months, 50 months, or 68 months, it seems the current one is likely late in its stage at 54 months as of September 2013.” Yes, I was saying 5 years ago the trend seemed late stage – and it was. It just continued anyway, though was interrupted by two declines in the range of -15% in 2015 and 2016.

At the same time in late 2013, the Shiller PE Ratio was increasing to a very overvalued level. It only kept going higher. By January of this year, it reached 33x earnings, the second highest ever. In fact, the only two times it reached this extreme the stock market followed with the Great Depression crash and the -46% decline after 2000. After the current -18% decline in the S&P it is now down to 26.74. The median is around 15, secular bear markets often begin at 20 or higher, secular bull markets begin below 10.

The bottom line is:

Shiller PE Ratio

I’m guessing the unprecedented Quantitative Easing of the Federal Reserve helped to push the valuations to an extreme. The Fed is now unwinding the QE and raising interest rates, which may be partly why we are seeing prices fall. So, we certainly can’t overlook the situational awareness that this could eventually become a much worse bear market to the -50% level. However, if it does, it will usually unfold with many swings up and down along the way. Falling prices are eventually followed by sharp countertrend moves up. It’s when we see lower highs and lower lows over time that it becomes more evident it’s a big bear market.

One thing that’s been talked about a lot lately is the risk of an inverted yield curve. An inverted yield curve is when the short-term 3-month interest rate is higher than the long-term 30-year interest rate. The yield curve hasn’t inverted like it did in December 2006 and August 2000. The yield curve doesn’t suggest a recession anytime soon.

Here’s what an inverted yield curve looks like… when it inverted December 2006. A year later, the stock market started its decline of over -56%.
Here is the inverted yield curve in August 2000. In 2000, the yield curve was more accurate as to timing. The broad stock market declined -50%.
The normal yield curve, 3 month vs 30 year, has not inverted. The long-term interest rate is higher than the short-term rate. For the yield curve to invert, the short-term interest rate will have to increase higher than the longer-term interest rate. Or, the long-term interest rate decrease below the short term. Either way, that hasn’t happened yet.

How big are the stock market losses in 2018? 

Starting with a top-down view. First, the broad asset classes and styles like large, mid, small and value, growth, and blend using Morningstar Small Value is down the most at -19% YTD. Small Cap stocks are down the most. Large Growth and Large Cap generally have declined the least. The average U.S. Market index is down -8.58%. Keep in mind that index performance does not include any costs or fees and may not be invested in directly.

stock market sector asset class performance 2018

The table above also includes sectors. Energy and Basic Materials are down over -20%, so any tactical system that avoided them had an advantage.

Most investors don’t necessarily invest all of their money in the stock market all the time. Many instead do global asset allocation like I wrote about in Global asset allocation takes a beating in 2018. Fewer have an objective like mine; a global tactical strategy that shifts between markets by increasing and decreasing exposure aiming for asymmetric risk/reward. Here are iShares asset allocation ETFs YTD as a proxy for low-cost exposure to a global asset allocation of stocks and bonds all the time with no active risk management or tactical decisions. Each “risk level” has a different exposure to stocks/bonds. Even the most conservative allocation which is mostly invested in bonds is down -4% in 2018.

global asset allocation etf

I shared more detailed observations of global asset allocation Global asset allocation takes a beating in 2018.

For a more exhaustive observation of GAA trends, here I included some of the more popular active global allocation funds along with the iShares ETFs that track allocation indexes. Clearly, 2018 has been a hostile year for most every strategy; static, balanced, or tactical.

global asset allocation funds 2018 ETF ETFs

So, that’s the big picture. From there, let’s zoom in for a closer look for a shorter term observation.

The downside very quickly erodes the progress. However, the asymmetric nature of losses starts to really compound against capital after -20%. At this point, the S&P 500 is down -18%. It’s a little lower than 2016 and about the same as the decline in 2011.

2018 stock market loss

Though this has been a very long bull market, it has been interrupted by deeper “corrections” of more than -10%.

stock market drawdown bear markets asymmetric risk

In comparison, the 2003 to 2007 bull market corrections were less than -10%.

stock market corrections bear market average

When does the bleeding stop? 

After prices have already fallen, I start looking for signs of a potential countertrend and divergence.

The price trend itself is the final arbiter. It is what it is. A price that is trending down is going to continue to trend down until the desire to sell has been exhausted and drives prices low enough until the enthusiasm to buy takes over. After sharp selling pressure like we’ve seen since September, we’ll likely see some similarly sharp countertrend reversals up. Market trends don’t usually drift in a direction until it’s over, instead, we observe swings up and down as the price trend cycles. Short term cycles develop the longer term cycles.

Though the price trend itself is the final arbiter, the best way I have identified when trends are most likely to change direction at extremes is to observe extremes in investor sentiment and breadth. Ultimately, investor sentiment and the breadth is evident in the price, but at extremes, these measures can be a warning shot across the bow at high levels and indicate panic selling exhaustion at lows. From here, we’ll look at investor sentiment measures. We’ll also look at breadth indicators that quantitatively tell us the breadth of participation in the decline. The thinking is at some point these measures reach an extreme, suggesting the selling may be becoming exhausted and to prepare for a potential reversal. Since asymmetric risk/reward is my objective, I’m looking for lower-risk entries that have the potential for greater payoff than the amount I risk.

Investor Sentiment: Fear is Driving the Stock Market

A simple way to quickly observe overall investor sentiment is the Fear & Greed index, which tracks seven different indicators.

Fear Greed Index Low 2018 lowest levelIt’s the lowest level I’ve seen it, suggesting we’ve observed panic level selling. If you read my observations from the beginning of this year, you’ll see the opposite was true at the start of 2018.

FEAR GREED INDEX 2018 LOW

We’ve observed a round trip this year from Extreme Greed to Extreme Fear. Investor sentiment obviously swings up and down over time. As sentiment oscillates, it drives price tends to cycle, too. Even in bull markets, there are declines and in bear markets, we’ll see sharp upswings.

When investor sentiment is so bearish we see a spike in the words “bear market.” Google Trends shows the bear market talk on the Internet has spiked to the highest level in five years, even higher than 2015-16 and February this year.

GOOGLE TRENDS BEAR MARKET STOCK

I’m also hearing the typical talk about a 1987 type crash. The October 1987 -20% single day crash was 32 years ago but it’s still talked about today when prices fall. Markets are risky, so a crash is something we risk when we invest our money. The risk is partially why markets generate a return. We have to be willing to have exposure to risks that can come when no one expects it. Has modern market regulation and technology created any prevention of an ’87 type crash? Around 2012 circuit breakers were created to theoretically prevent a single day crash.

Circuit breaker thresholds: trading is halted market-wide for single-day declines in the S&P 500. Circuit breakers halt trading on the stock market during dramatic drops and are set at 7%, 13%, and 20% of the closing price for the previous day. There are also single stock limits and halts by the exchanges

Buy and hold, long-only asset allocation investors may take comfort in knowing there is some limit, but for those of us who actively manage our risk we prefer to deal with risk sooner if we can, but there is no assurance any strategy will always do as intended.  You can read more about circuit breakers in Measures to Address Market Volatility. The bottom line is these circuit breakers are intended to limit a single day waterfall decline, they do not control overall drawdowns.

How many stocks are participating in the decline? 

Another way to say it; How “washed out” is the stock market? To understand the internal condition, I look inside the indexes at the sectors and stocks. We’ll start with Breadth indicators, which quantitatively measure the percent of stocks in uptrends vs. downtrends.

  • When 70% of stocks are already in uptrends it signals a strong market trend but also suggests as most stocks have caught up and participated, buying enthusiasm may be getting exhausted.
  • When less than 30% of stocks are in uptrends, 70% of them are in downtrends, so the market trend is bearish. However, after most of the stocks have already fallen, at some point, it suggests we look for the exhaustion of selling pressure that could reverse the downtrend.

The percent of the S&P 500 stocks above their moving averages tells us how many of the 500 stocks are in an uptrend vs. a downtrend. When it’s declining, the market is bearish so we can see how many stocks are participating in the decline. When it reaches an extreme low, it may be an indication selling could be becoming exhausted. As we see, it has reached the low levels of past stock market lows with the exception of the low in March 2009.

PERCENT OF STOCKS ABOVE 200 DAY MOVING AVERAGE

Notice the low was reached October 2008 and stayed down until late March 2009. In the massive crash when stocks fell over -50%, it stayed “oversold” for over 6 months. It’s an example of the limitations of countertrend signals in outlier events.

For a view of the short-term trends, I do the same for the 50 day moving average. Only 6% of the S&P 500 stocks are in uptrends, so 94% are in short-term downtrends. That’s the bad news for stock investors. The good news is, it’s reached the low range where we have historically seen a reversal up. A reversal up from here would be bullish, at least temporarily.

PERCENT OF STOCKS ABOVE 50 DAY MOVING AVERAGE

The S&P 500 Bullish Percent Index is the number of stocks in the S&P that are trading on a Point & Figure buy signal. By this measure, only 17% of the 500 stocks are in uptrends. I highlighted the top are in red to note the contrary indicator of breadth and green on the bottom to mark the contrarian bullish zone where downtrends may reverse to uptrends when selling gets exhausted. The S&P 500 Bullish Percent Index is below 2011, 2015 and 2016 stock market correction lows. BPI is considered overbought when above 70% and oversold when below 30%. Once it reaches the green zone, I start looking for a reversal up from a low level, which is a bullish signal. 

S&P 500 BULLISH PERCENT $BPSPX

Notice the current level is below the 2011 and 2015-16 decline, but not as low as the 2008-09 bear market when the stock index fell -56%.

We see the same scenario in the NYSE Bullish Percent, which applies the same method to the stocks trading on the NYSE.

NYSE BULLISH PERCENT

We’re not seeing any divergence in the breadth indicators, they are all down as most stocks have fallen. These are now at the level to look for countertrend signals.

The High-Low Index is a 10-day moving average of new highs vs. new lows. This breadth indicator shows when new highs outnumber new lows and when new highs are expanding. In general, new highs outnumber new lows when the indicator is above 50. New highs are expanding when the indicator is above 50 and rising. As with most range bound oscillator indicators, high is over 70 and low is below 30. Here we see it’s about as low as it has been. We also see how it can swing around for a year or two in a bear market. Since it can take time for prices to reach all-time highs and lows, the High-Low Index is more lagging than similar indicators.

High Low HILO SPX

Before we look inside the sectors, we’ll look at some other indicators of sentiment. This week, the CBOE Total Put/Call Ratio spiked to 1.82, which is its highest put volume over call volume ratio ever. We have data going back to 1995. As you can see in the chart, we normally see this ratio less than one as more calls trade than puts. A reading over 1 is usually a signal of pessimism as options traders appear to buy buying put options for protection or to speculate the stock market will fall. We’ve never seen put volume so high. Options traders appear to be very bearish, which has historically been a contrarian indicator at some point.

PUT CALL RATIO HIGHEST EVER 2018

By the way, big bear markets unfold in cycles as the trend swings up and down. In the last bear market, the stock indexes fell -15%, then gained 10%, then fell 20%, then gained 15%, along the way you never know in advance which direction it is going to trend next. Many tactical traders had trouble with the 2007 to 2009 period because of whipsaws. By the time they exited, the market trended up without them, then they reentered just in time for the next fall. This is the risk of tactical trading, whether the method is breakouts, momentum, relative strength, or any other rotation style. I know this because I’ve known over 100 other tactical traders for over two decades. The price swings are the challenge. For example, below is the 2008 – 2009 -56% decline. As you can see, the Equity Put/Call Ratio is on top. I drew green lines at its peaks to show they typically indicate a short-term price low, but probably not as well as it would in a correction within a primary bull market. The point is, sometimes signals work out well, other times they don’t. They don’t have to be perfect and none are. The key is asymmetry: higher average profits than losses over full market cycles.

2008 spx put call ratio study

One indicator showing some divergence is the VIX CBOE Volatility Index. Although the S&P 500 is about -5% lower than its February low when the VIX spiked up to nearly 40, the VIX is only at 30 this time. However, I point out it did the same thing in the lower low in January 2016. The VIX initially spiked more in the first decline in August 2015 but remained less evaluated at the lower low in January 2016. It appears the options market  expects elevated volatility, but not as much as an expansion as before. We’ll see.

VIX DIVERGENCE VOLATILITY EXPANSION

Drilling down, what about sectors? Below are the individual sectors YTD. Energy and Materials are down the most. Ironically, they are tied to inflation. Where is the rising prices (inflation) the Fed is supposed to be fighting?

SECTOR SPDRS MOMENTUM RELATIVE STRENGTH

Sector Trends and Breadth 

To get an underatnding of the individual stock trends within a sector, I look at the bullish percent of the sectors.

First, we’ll observe the bullish percent of the Energy sector. Energy is down the most and only 3% of stocks in the index is an uptrend as measured by a point & figure buy signal. It’s as low as its been in 20 years. Though it could stay at this low level in a bear market as it did around 2008, it still swings up and down for those willing to trade it.

BULLISH PERCENT ENERGY SECTOR

The next biggest loser sector is Basic Materials, another commodity-related sector. I highlighted the current low level in green, which is nearly as low as it’s ever been in 20 years. These indicators are range bound, so they can only fall to 0% and as high as 100%.

BASIC MATERIALS SECTOR BULLISH PERCENT

The Financial sector is the third largest weight in the S&P 500 stock index at 13%. It’s down -18%, making it one of the biggest laggards. Banks, brokers, etc. are leading the market down and that isn’t a good sign for the economy of the market. Financials often lead in bear markets. However, as we see below, their participation in the fall is about as high as it’s ever been. On the other hand, we see how volatile and weak Financials were in 2007 to 2009. During that “Financial Crisis”, they were among the worst.

financial sector bullish percent momentum relative strength

The industrials sector, down about -18%, continues the trend of broad participation in the sell-off. It’s also reached the lowest it did in 2008 and 2011.

industrial sector bullish percent momentum

Consumer Staples is a sector that is supposed to hold up in market declines, but the index is down -12% year to date, which is more than the S&P. Staples stocks have participated as much as they did in prior corrections in 2011 and 2016, but not as much as around 2008.

consumer staples sector bullish percent index

The Technology sector is a big one because at 20% it has the largest weighting in the S&P 500. The Technology sector is down about -7% YTD. The Technolgy sector bullish percent is down below its lows in prior corrections and nearing the 2008 and 2009 lows. Keep in mind, once prices have moved to a low point, they eventually attract buying demand and reverse the other direction. These indicators help us see the levels it is more likely to happen and a reversal in these indicators increases the potential even more.

BULLISH PERCENT TECHNOLOGY

Consumer Discretionary is 10% of the S&P and down -5% YTD. Its bullish percent is as about as low as it’s been.

BULLISH PERCENT CONSUMER DISRCRETIONARY SECTOR

Another major sector is Healthcare, it’s the second largest weighting at 16% of the S&P 500. It’s flat for the year, but its bullish percent is very washed out.

HEALTHCARE SECTOR BULLISH PERCENT MOMENTUM RELATIVE STRETGH

The Utility sector is the lone survivor so far in 2018. Like Consumer Staples, Utilities are considered “defensive.” That expectation hasn’t held true for Consumer Staples down -12% this year, but the Utility sector is up 2% YTD. The first half of the year, Utilities were laggard as they are sensitive to rising interest rates, but the last half they’ve found some buying interest. As we see, the Utility sector momentum has been strong enough to keep its stocks in uptrends and into the higher risk zone. However, notice they tend to stay at higher bullish percent levels over time. Utilities don’t usually have strong momentum against other sectors, but they do tend to have less volatility. Of course, in the last big bear market that wasn’t the case as everything fell.

UTILITY SECTOR MOMENTUM TREND BULLISH PERCENT RELATIVE STRENGTH

The bottom line is the stock market could certainly be entering another big bear market. It’s long overdue as this bull is very aged and overvalued. Even if it is, it will include swings up and down along the way. That’s the challenge for all strategies that trade or invest in stocks. For buy and hold investors, it’s a challenge as stocks swing up and down and they have full exposure all the time and unlimited downside risk. For tactical traders, the swings are a challenge as we increase and decrease our exposure to risk and reward and none of our methods are perfect. The key, for me, in dealing with it is to hold the lowest risk, highest potential reward exposure. Barring we don’t see some waterfall decline, most of the market is at a point we should see a countertrend move up at least temporarily. If prices keep trending down, I’m guessing the upswing that does come will be just as sharp.

After prices have fallen, I start looking for signs of a potential countertrend and it could come at any time.

Someday in the future, stock investors will be giddy again and completely forget about how they feel right now. But for now, the trend is down, but the sentiment and breadth are at such extremes we should be alert to see at least a short-term reversal in the days ahead.

I hope you find this market analysis helpful. If you don’t believe it is exhaustive enough, I encourage you to read some of the other recent observations since they cover more detail on some of the topics above.

Have a Merry Christmas!

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 has reached a short-term extreme as investor sentiment indicates fear

After prices have fallen, I start looking for signs of a potential countertrend and divergence.

“Be fearful when others are greedy and greedy when others are fearful.”

– Warren Buffett

If you want to be like Warren Buffett, you’re probably enjoying the recent rout in stocks.

The U.S. stock market is now oversold based on short-term relative strength measures. Our 14 day RSI reading has declined to 28, which is at oversold levels that have historically signaled countertrend reversals up.

RSI RELATIVE STRENGTH INDEX STOCK MARKET ASYMMETRIC

The trouble is, market prices can reach oversold levels and just keep getting more oversold for a while. For example, when the S&P 500 declined -56% from October 9, 2007 to March 9, 2009 it got deeply oversold several times as the price trend cycled up and down. We can visually observe the Relative Strength Index spent more time in the lower range as prices were falling. Then in 2009 as prices finally trended up momentum stayed elevated.

2008 and 2009 oversold stock crash

Another indication of an oversold condition I observed today is when we draw bands of ATR around the price trend to measure volatility expansion. ATR is the average true range of the price over the past 14 days, a short-term measure of range and volatility. When the prices spread out, so does the band as it indicates volatility expansion. Today the price of the S&P 500 declined below the band, so the recent price action on the downside is an outlier by this measure. As you can see, the last time the price traded below the volatility band was the February low. What this observation suggests is the price has moved down low enough that it’s a short-term outlier, so it should trend the other way (at least temporarily).

STOCK MARKET ATR SPX

Stock market breadth indicators measure the participation of a stock advance or decline. The percent of stocks above their 200 day moving average tells us how many stocks are still in longer-term uptrends vs. downtrends. After today, only 18% or 89 stocks are above their 200-day trend. It’s now down to the low level reached during the August 2015 to January 2016 lows. After it reached this low in 2016, stocks went on to trend up to a new all-time high.

stock market breadth percent of stocks above 200 day moving average

At this point, the S&P 500 and Dow Jones have declined -15% from their September high. If this is a cyclical “correction” within an ongoing bull market, we should see prices trend up soon and eventually trend to a higher high.

However, even if this is the early stages of a bear market that declines over -20% or a big bear market like 2000-2003 and 2007-2009 that declines -50%, the stock market will still likely swing up and down along the way. As we saw in the above chart that included the last bear market, the stock indexes swing up and down 10% to 20% on their way down just as they do on their way up. Some of these swings can be traded, some not so well. This recent decline since September was probably more challenging for tactical traders. Though the stock market got overbought enough in September to signal reducing exposure near the high, after prices fell to a lower level and signaled a countertrend entry, the price trend has since kept falling. But, at this point, countertrend systems now have a stronger entry signal than before. The challenge with countertrends is a trend can always continue trending farther. That is, oversold can get more oversold until sellers have been exhausted and buyers are attracted by the lower prices. Prices keep trending until the supply and demand shifts direction.

By the way, on September 1st I shared the countertrend signal reduce exposure in The U.S. stock market was strong in August, but… when I concluded:

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.

Because of this, I reduced my exposure to only 70% long stocks around the September high. However, we still participated in the October rout more than I planned because the 30 % of stocks we held that were former leaders declined the most. I then started adding exposure to stocks at lower prices and so far, they’ve only trended lower. Everything is always probabilistic, never a sure thing.

Anytime we see stock prices decline more than -10% the narrative we hear in the media changes from “correction” to speculation of a “bear market”. As I mentioned a few days ago, this is the longest bull market in U.S. history and the second highest valuation. As such, anything can happen. However, at this point, this decline of -15% is around the range of the 2015-16 decline and the 2011 decline.

Here is what the August 2015 to January 2016 declines looked like.

2015 stock market decline asymmetric risk

In 2011, the correction was the deepest we’ve seen since this bull market started in March 2009.

2011 stock market drawdown asymmetric risk reward

To put it all in context of a major bear market like the last one 2007 to 2009 when the stock index declined -56% over two years and took another four years to return to its 2007 high, I marked -15% green. The stock market was already down -15% from its October 2007 high by January 2008 – two months later. The bear market had many countertrend swings back up giving many who were holding some hope, but it ultimately cycled its way down to cut stock portfolio values in half.

2008 stock market crash drawdown

Many say they are “long-term investors.” The long-term investors who buy and hold stocks or the stock indexes have to be willing to hold through an astonishing loss like -50%.

I am not willing to hold on to losing positions near that long or let my losses get that large. But even for a tactical portfolio manager like myself, I have to be willing to expose our capital to risk and endure some drawdowns. I just choose to limit my drawdowns by predefining risk through my exits and/or hedging. I prefer to avoid the price action below the green line in the chart above.

This has been one of the worst ends of the year in history. In fact, as of now, this is the 2nd worst December in S&P 500 history. It is the worst in MSCI World global stock index history.

worst decemember in history

The only good news I can share is the stock market has reached an oversold level based on short-term momentum and investor sentiment measures are at extreme bearish levels. Both are contrary indicators. These indicators normally signal a reversal back up at some point. Although, if enough investors wish they had sold, they may sell as prices trend up, so the trend could swing around for a while. It means volatility may continue for some time.

Todays AAII Investor Sentiment Survey shows optimism and pessimism remain outside their typical ranges: bullish sentiment is unusually low and bearish is unusually high. Historically, both have been followed by higher-than-median six- and 12-month returns for the S&P 500 index, particularly unusually low optimism. Again, this is a contrary indicator as investors as a crowd tend to feel the wrong feeling at the wrong time at extremes.

AAII Sentiment Survey

The fear and greed index that measures investor sentiment using multipe indicators is down to five, which is about the most extreme fear level it’s ever been.

investor sentiment fear greed index

One of the indicators in the Fear and Greed Index is the Put/Call Ratio is used as a contrarian indicator to gauge bullish and bearish extremes. The sentiment is considered excessively bearish when the Put/Call Ratio is trading at relatively high levels. One a normal day, the Put/Call Ratio is less than one since options traders tend to trade calls more than puts. Today the Put/Call Ratio is at 1.82, so options traders are buying many more puts for protection against a market decline or as a directional bet. Put/Call Ratio is at 182% is an extremely high level, the highest ever recorded. The Put/Call Ratio data goes back to 1995 and 1.2 has historically been an extreme high.

Put Call Ratio 2018 December highest ever recorded

The bottom line is, fear of lower prices is driving the stock market, and the bears have been in control. However, sentiment has reached such an extreme we would expect to see a countertrend reversal up at least temporarily. Even if this is the early stage of a lower low and a bear market, it will include many swings up and down along the way. What the trend does once it finally drifts up will be telling of the bigger picture. Bear and bull markets are both a process, not an event. In a bear market, prices trend up down to lower lows and lower highs. The swings along the way result in fear of missing out and the fear of losing more money which leads to overbought and oversold conditions.

I believe risk must be actively managed through increasing and decreasing exposure to the possibility of loss because markets are risky. The stock market can decline -50% or more and take years to trend back up, so I believe drawdown controls are necessary to preserve capital rather than allowing losses to get too large. Once a portfolio declines more than -20%, the losses grow exponentially and become harder to recover.

We’ll see how it all plays out. We’re still waiting to see those investors who are “greedy when others are fearful” overwhelm the sellers enough to change the trend.

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.

Global asset allocation takes a beating in 2018

Most financial advisors and financial planners recommend to their clients some type of global asset allocation. Their global asset allocation models usually include a range of bonds, U.S. stocks, and International stocks. Some may include what are considered alternative investments like real estate (REITs), private equity, or tactical trading, but most of them keep it plain vanilla. This asset allocation method is called “strategic asset allocation” since it usually applies some form of portfolio optimization of historical returns and volatility to determine the weight between stocks and bonds.

Who can blame them? asset allocation and diversification is easy to sell and easy to defend. If someone sells their business or retires with a large 401(k), it’s easy to sell them on diversifying their assets. If the markets go down it isn’t their fault, it’s the market that’s doing it. Is it too much drawdown or volatility? They just recommend a change to less stocks and more bonds. Of course, that only works when bonds aren’t falling too.

Since many actively managed mutual funds failed to avoid losses during the last bear market 2007 to 2009, many advisors shifted their strategic asset allocation from actively managed mutual funds to index funds. It’s easy to see why; their clients lost a lot of money, even as much as -40% for a balanced portfolio of 60% stocks and 40% bonds. If they were more invested in stocks, it was as much as -50% or more.

If a mutual fund was supposed to be “active,” I can see how such losses would be unacceptable. If an investor is paying more for portfolio management, they probably expect to have a more asymmetric risk/return profile than what long-only exposure to stock indexes all the time would provide for less cost. Index funds and ETFs are cheap because they simply provide exposure to market risks and rewards. They provide this exposure all the time, so when markets fall as they do in a bear market, they lose value and have no stop loss for risk management.

I also use index ETFs to gain exposure to markets, countries, and sectors, but I don’t just buy and hold them, I increase and decrease my exposure to actively manage my risk/reward. My objective is an asymmetric risk/reward, so I want to avoid the larger losses as I try to capture gains. For me, it starts at the individual position level and flows through to the portfolio level. I’m entering positions we expect to result in an asymmetric risk/reward payoff; positions with a higher expected gain than its potential loss. I do this over and over, and they don’t all have to result in asymmetry. We just need the average gains to exceed the average losses over time to achieve a positive asymmetric risk-return profile. It’s an absolute return objective, meaning our focus is on our own payoffs and risk-reward profile, not trying to track what a stock index is doing. My strategy is unconstrained from the limitations of a fixed benchmark. Our objective is more about making money with a predetermined amount of absolute risk, not relative returns and tracking indexes. As such, the return stream is expected to be unique.

That isn’t what active mutual fund managers do.

The typical active mutual fund has an objective of relative return vs. an index benchmark. As I’ve been an investment manager for over two decades, I’ve seen the relative return comparisons become more and more intense. Brokerage firms and investment advisors have created sophisticated performance reporting programs to compare their performance to chosen benchmarks. Active mutual funds have a mandate to “beat” and index. For example, some of them aim to beat the large growth, mid value, or small growth asset classes. Most of them attempt to beat their benchmark by filtering through the stocks in the index and picking better stocks. If a relative return is their objective, they are not focused on managing downside risk. Instead, they are focused on tracking the benchmark and getting ahead of it. Many of them probably attempt it by holding a more focused portfolio or with a portfolio of the higher momentum stocks relative to the benchmark. Since risk management isn’t their objective, they view any overweight in cash as a risk of underperformance. That’s what traditional “active managers” do. What I do is typically called “tactical management” since my objective is absolute return, not relative return, and I want to actively control my drawdowns through risk management. For example, I could be positioned in all cash in a bear market, hedged, short, or long volatility.

So, there is an important distinction between “active managers” with a relative return benchmark-beating objective and those of us with an unconstrained strategy and focus on absolute returns. Mutual funds are typically relative return managers trying to beat a benchmark, hedge funds are typically absolute return managers creating their own unique return stream. Although, typically means that isn’t always the case.

Ok, so, the headline was about the performance of Global Asset Allocation this year.

Back to global asset allocation.

Some financial advisors and media enjoy disparaging all types of active management. They talk about how relative return managers like most mutual funds don’t beat their benchmarks. They’ll point out how absolute return hedge fund type strategies may manage downside risk, but don’t earn as much return as an all-stock portfolio. Most of the time, it isn’t a reasonable comparison. For example, saying the Barclays Hedge Fund Index underperformed the S&P 500 the past decade isn’t complete without also considering the drawdowns. In the last bear market, the S&P 500 declined -56% while the Barclays Hedge Fund Index that includes a composite of thousands of hedge funds declined only -24%. I will suggest the stock index loss was so large most tapped out while the Barclays Hedge Fund Index was low enough that investors could have held on.

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

This year has been a challenging and hostile year for all investment strategies.  While those who adhere to a long-only fully invested asset allocation all the time will talk about the performance of active managers, theirs isn’t much to speak of, either. I know a lot of advisors, and we work with some who invest in my portfolio. Most of their global asset allocations are very simple, and now many of them use index funds and charge an advisory fee for the asset allocation and rebalancing.

There are some mutual funds that offer a varying method of asset allocation. I am not recommending any of these funds, this is for educational and informational purposes only. Some popular ones that come to mind are BlackRock Global Allocation (MDLOX), Arrow DWA Balanced. PIMCO All Asset All Authority (PAUAX), DFA Global Allocation 60/40 (DGSIX). BlackRock Global Allocation, Arrow DWA Balanced, and PIMCO All Asset All Authority are active allocation funds while DFA Global Allocation is a passive allocation fund managed by Dimensional Fund Advisors. Below are their year-to-date total returns, including dividends. (To see their full history click on the links in their names above.)

Global Asset Allocation Funds

I know financial advisors who are big advocates of large asset managers like Dimensional Fund Advisors (DFA), PIMCO, and BlackRock. Advisors often tout how large they are and how many academics or how many analysts and portfolios managers they have on staff. I included the Arrow DWA Balanced fund because it’s managed by Dorsey Wright, which isn’t as large, but I know advisors use it. Most advisors who offer asset allocation models are doing their own asset allocations for their clients. The above returns are the result of each of these asset managers doing the allocation and investment selection. So, I would expect when it comes to global asset allocation, those funds should be as good as it gets. How is a financial planner who isn’t a portfolio manager going to do better?

Some may say “What about Vanguard? They are some of the cheapest funds you can buy?”. I don’t know of a Vanguard global asset allocation fund like the DFA fund, but they do have a balanced 60/40 fund that doesn’t include exposure to international. Below is their balanced allocation fund along with their International stock fund. Though their fund isn’t down -7% like the global allocation funds, if you added 20% of their International to make it “global,” we can see it would be similar.

vanguard asset allocation funds

Since indexing and ETFs have become more popular than mutual funds, today we have some interesting ETFs that track global asset allocation indexes so we can better understand the return streams of global asset allocation.

iShares is a BlackRock company, the world’s largest asset manager with $6.29 trillion in assets under management. If an investor thinks a large size with many professionals is the key to investment success, they would probably BlackRock is the best. Of course, I don’t agree, since the most skilled portfolio managers I know are small, focused, specialized firms with all their skin in the game. BlackRock’s iShares offers the iShares Core Allocation Funds, which are ETF allocations of ETFs. Each iShares Core Allocation Fund offers exposure to U.S. stocks, international stocks, and bonds at fixed weights and holds an underlying portfolio of iShares Core Funds. Investors can choose the portfolio that aligns with their specific risk considerations like investment time horizon and risk tolerance; for example, those with longer investment time horizons and higher risk tolerance may consider the iShares Core Aggressive Allocation ETF.

More specifically, the iShares Core Allocation Funds track the S&P Target Risk Indexes. So, not only do you have BlackRock’s portfolio management managing the fund, but they are tracking S&P Target Risk Indexes. Here is their description:

S&P Dow Jones Indices’ Target Risk series comprises multi-asset class indices that correspond to a particular risk level. Each index is fully investable, with varying levels of exposure to equities and fixed income and are intended to represent stock and bond allocations across a risk spectrum from conservative to aggressive.

In other words, they each provide varying allocations to bonds and stocks. The Conservative model is more bonds, the Aggressive model is more stocks.

S&P Target Risk Conservative Index. The index seeks to emphasize exposure to fixed income, in order to produce a current income stream and avoid excessive volatility of returns. Equities are included to protect long-term purchasing power.

S&P Target Risk Moderate Index. The index seeks to provide significant exposure to fixed income, while also providing increased opportunity for capital growth through equities.

S&P Target Risk Growth Index. The index seeks to provide increased exposure to equities, while also using some fixed income exposure to dampen risk.

S&P Target Risk Aggressive Index. The index seeks to emphasize exposure to equities, maximizing opportunities for long-term capital accumulation. It may include small allocations in fixed income to enhance portfolio efficiency.

Below is an example of the S&P Target Risk Index allocations and the underlying ETFs they invest in. Notice their differences is the 10% to 20% allocation between stocks and bonds.

Global Allocation Index Construction

These ETFs offer low-cost exposure to global asset allocation with varying levels of “risk,” which really means varying levels of allocations to bonds. I say they are “low-cost” because these ETFs only charge 0.25% including the ETFs they are invested in. Most financial advisors probably charge 1% for global asset allocation, not including trade commissions and the fund fees they invest in. Even the lowest fee advisors charge at least 0.25% plus the trade commissions and the fund fees they invest in. With these funds, investors who want long-only exposure all the time to global stock and bond market risks and returns, they can get it cheap in one fund.

Now that we know what they are, below are their total returns including dividends year to date in 2018. (To see the full history click: iShares)

global asset allocation fund ETF

The % off high chart shows their drawdowns from their price high.

global asset allocation ETF ETFs

Global asset allocation is having a challenging year in 2018 because U.S. stocks, International stocks, and bonds are all down this year.

Of course, a calendar year doesn’t mean a lot. What we do over 15 or 20 years or more is what matters. But, as low-cost index asset allocation advisors talk about the performance of active managers and hedge fund type managers, 2018 has included conditions that have been hostile for all kinds of strategies.

As I said yesterday if this market volatility and correction develops into a full bear market, the asset allocations that are fully exposed to downside risk will test investors’ tolerance for drawdowns.

How deep can drawdowns be for such a globally diversified portfolio? Looking at the historical % off high of DFA Global Allocation and Vanguard Balanced gives a historical example. Even two of the efficient allocation funds available had drawdowns of around -35% to -40% in the last bear market. If it’s done it before, it can certainly happen again.

DFA Global Allocation Vanguard Balanced

Those of us applying active risk management and hedging strategies aim to limit the drawdowns within a tolerable amount rather than allowing them to become too large. For me, more than -20% becomes exponentially more difficult to tolerate and recover from. We have to deal with the -10% or so drawdowns sometimes since we can’t avoid them all. We necessarily have to take some risk to gain exposure to the possibility of gains.

Ok, so my headline was a little exaggerated. Drawdowns of -5% to -12% isn’t exactly a “beating”, but that’s the kind of headline we often see about active management and hedge funds.

You can probably see why I believe it’s essential to actively manage risk and position capital in the direction of price trends.

 

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.

What’s going to happen next for the stock market?

The popular stock indexes are now down about -5% year to date.

dow jones stock market

The popular stock indexes are now about -13% off their highs.

stock market dow jones spx spy dia

I don’t normally include the NASDAQ since it’s so overweight the Technology sector, but it’s down -17% off its high and the Russell 2000 small-cap index is down -19%. The year started off very strong and is ending with weakness so far.

nasdaq russell 2000 dow jones

I pointed out earlier this year that Emerging Markets and Developed countries stock markets were already in a bear market if we define it as -20% off highs. Here we see they are down even more than the U.S. stocks year to date.

emering markets stocks

I warned before that with interest rates rising, bonds may not provide the crutch they have in past stock market declines. That has been the case in 2018. Even with the long-term Treasury gaining recently from being down -12%, it’s still down -6% year to date.

BOND ETF TLT LQD AGG ETFS

Many investors are probably wondering what’s going to happen next. I said a week ago in Stock Market Observations that stocks have fallen far enough that “We would expect to see some potential buying support at these levels again.” For these popular stock indexes, they are now at the point of the February and April lows and reaching an oversold level by my momentum measures.

We are looking for signs that selling pressure is drying up as those who want to sell have been exhausted and new buying demand increases to take over. Some signs of stock prices reaching a low enough point to attract more buying than selling are observed in investor sentiment measures and breadth indicators.

A simple easy to follow gauge of investor sentiment is the Fear & Greed Index, which is a composite of seven Investor sentiment measures. The investor sentiment reached an “Extreme Fear” zone again.

investor sentiment fear greed index

Investor fear by this measure has been high for the past few months. At some point, we would expect to see those who want to sell have sold. However, if this stock trend becomes a bear market we would expect to see this gauge remain low for a long time. Although, the stock indexes will swing up and down along the way.

fear and greed over time investor sentiment stock market

Another observation of investor sentiment reaching an extreme was last week’s AAII Investor Sentiment Survey. Last week pessimism spiked to its highest level since April 2013, while optimism fell to an unusually low level.

bearish investor sentiment

For some historical context, the % of bearish investors has reached the high level it did at the 2016 stock market low. When investor fear reaches such extremes, it’s a contrary indicator.

bearish sentiment

A bear market is a process, not an event. At -13% it’s hard to say if this will become a bear market, though there are some potential drivers that could cause stocks to fall more over time.

The first warning sign for the big picture is earlier this year the Shiller PE ratio for the S&P 500 reached the second highest level ever, with data going back before 1880.

Shiller PE ratio for the S&P 500

The only two times the Shiller PE ratio for the S&P 500 had reached this “overvalued” level was 1929 and 1999. Of course, 1929 was followed by The Great Depression and 1999 was followed by the Tech Bubble Burst. The only time I pay attention to the PE ratio is for a big picture assessment of valuation when it reaches extreme highs or lows. At such a high level of valuation, we shouldn’t be surprised to see volatility and stocks decline. The unknown is if it keeps declining much more to reach an “undervalued” level at some point. So far, with -13% decline, the Shiller PE ratio for the S&P 500 has declined from 33 at the beginning of the year to 28 now. Twenty or higher is considered high, 10 or less is considered low. It is what it is.

A bear market is a process, not an event, which means the stock market will swing up and down along the way. For example, historical bear markets are made up of swings of -10%, +8%, -14%, +10%, each swing doesn’t make a higher high, but instead prints a lower high and lower lows. The good news is, the swings are potentially tradable. However, for those tactical traders who attempt to trade them, it isn’t easy and it doesn’t always feel good. These kind of periods are volatile, so a skilled tactical trader has to increase and decrease exposure to the possibility of gain and loss. For me, predefining risk is essential, but so is holding the predetermined exposure to give a trend room to play out.

Some potentially positive news is the breadth indicators suggest most stocks are participating in the downtrend. That doesn’t sound positive unless you realize as stocks get washed out on the downside the selling pressure is eventually exhausted, at least temporarily. Below is one indicator we observe to see what is going on inside S&P 500 stock index. It’s the percent of the 500 stocks in the index that are trending above their 50-day moving average. When this indicator is low, it signals stocks may be nearing a level of selling exhaustion as most of them are already in downtrends. However, if this does become an actual bear market of -20% or more, we’ll see this indicator swing up and down along with the price trend. At this point, it’s in the green zone, suggesting the stocks may be near the “washed out” area so we could see some demand take over supply in the days or weeks ahead.

As you can see below, the percent of stocks above their 50 day moving average has now reached the low level it did in February and back in August 2015 and January 2016 that preceded a reversal back up.

percent of stocks above 50 day moving average

I shared my observations of this breadth indicator back in February when I explained it in more detail if you want to read it Stock Market Analysis of the S&P 500. I also shared it in October when the current downtrend started. In October, the percent of stocks above their 200 day moving average was still high and hadn’t declined much. That isn’t the case now. As you can see, even this longer term breadth indicator is now entering the green zone. As more stocks have already declined, it becomes more and more likely we’ll see selling exhausted and shift to buying demand as prices reach lower more attractive levels for institutional investors.

As you can see below, the percent of stocks above their 200 day moving average has now reached the low level much below February and now down to the levels reached in August 2015 and January 2016 that preceded a reversal back up in stocks.

stock market breadth percent of stocks 200 day

Another indicator that measures the participation in the trend is the S&P 500 Bullish Percent index that I have been observing for over two decades. This is the percent of stocks on a Point & Figure buy signal, which often traces a pattern something similar to the 50 day and 200-day moving averages as it has the past four years. As we see below, this indicator is reaching the low level not seen since August 2015 and January 2016 that preceded a reversal back up.

buliish percent index

At this point, we haven’t yet seen enough buying enthusiasm to overwhelm the desire to sell. But, many of these indicators I’ve been monitoring for nearly two decades are reaching a level we should see some shift at some point. If we don’t, the stock market may enter into a more prolonged and deeper bear market. However, historically lower lows are made up of cycle swings along the way, so we should still see at least some shorter-term uptrends.

I’m starting to hear a lot of “bear market” talk in the news and on social media, so I thought I would put the current decline into context. My mission isn’t to take up for the stock market, but instead to present the facts of the trends as they are. I was defensive at the beginning of the year and then added more exposure after prices fell. I predefine my risk by predefining my exits in all of my positions, so any exposure I have has a relatively short leash on how low I’ll allow it to go before I cut my loss short, rather than let the loss get large. I am never a market cheerleader, but because I was already defensive near the peaks, I may have the potential to take advantage of the lower prices. I’m almost always going to be a little too early or a little too late and that is fine. It’s never been perfect but has still achieved the results I want the past two decades.

To put the current decline into historical contacts, we can simply compare it to the last decline of -10% or more, which was around August 2015 and January 2016. For nearly two years, the stock index was range bound with no upside breakout.

stock market 2015 2015 decline bear market

Looking closer at the % off highs, we see the late 2015 decline was -12% and the first few months of 2016 was about -15%.

stock market decline 2015 2016 asymmetric risk reward

Here is 2018. So far, it isn’t actually as much of a decline.

bear market stocks stock market

Another interesting observation I’ll share is the trend in the CBOE S&P 500 Volatility Index (VIX). Below is the 2015 to 2016 period again with the S&P 500 in the top panel and VIX volatility index in the bottom panel. We see the VIX spiked up sharply around August 2015 when the stock market decline. However, when the stock market recovered the loss and then declined again to a lower low, the VIX index didn’t reach the same high level the second time. The volatility expansion wasn’t nearly as high even though the stock index reached an even lower low.

VIX VOLATILITY expansion 2016

We are observing that same divergence in volatility this year. The VIX spiked over 100% when stocks fell -12% around February this year. The stock market recovered and printed a new high in September, then has since fallen -13% from that high. This time, however, the implied volatility VIX index hasn’t spiked up nearly as high.

divergence volatility expansion vix

What could it mean? When the VIX increases it is an indication of expected future 30-day volatility implied by the options on the stocks in the S&P 500. When the VIX increases, it means options traders are probably using options to hedge against market declines. I’m guessing it could signal that hedging and possible selling enthusiasm could be drying up. That seems to be what it suggested in 2015 to 2016 when it did the same, then the stock market trended up into 2017.

We’ll see how it all unfolds from here, but the stock market has clearly reached an inflection point. Stocks have trended down to a low enough level we should see some buying demand if it’s there. You can probably see why I believe markets require me to actively manage my risk through predefined exits and hedging to extract from it the asymmetric risk-reward I want.

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.

Stock Market Observations

The S&P 500 stock index retests October low for the third time. It is only 1.2% above the February and April low, but so far holding the line.

SPY STOCK MARKET

We would expect to see some potential buying support at these levels again. In fact, we’ve already observed some positive reversal today from lower levels. At one point the S&P 500 was down nearly -2% and has reversed back up to near positive. If the lower prices continue to attract buying interest and the current intraday trend continues it could close positive.

SPY VWAP

I pointed out earlier in the year the rising implied volatility indicated by the CBOE S&P 500 Volatility Index was expecting a volatility expansion. The VIX correctly predicted a volatility expansion in 2018.

VIX SPY SPX VOLATILITY EXPANSION ASYMMETRIC

At this point, the Technology, Communication Services, and Materials sectors have turned positive for the day.

SECTOR ETF ROTATION TREND FOLLOWING

Three sectors that have trended above their April lows are Technolgy, Healthcare, and Consumer Discretionary.

trend following stock market sector etfs

The bottom line is when stocks reach a low enough point to attract new buying demand that overwhelms selling pressure, we’ll see the stock market trend back up. We should soon see if the stock market trends down well below its prior lows into a potential bear market level or reverses back up to continue its longer-term uptrend.

The direction of the trend conveys the truth.

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 Death Cross on the S&P 500

I wonder when we’ll start hearing about the death cross again like we did in 2016.

The S&P 500 Equal Weight signaled a death cross today. As with any trend following signal or any signal at all, it doesn’t come with a 100% probability. No signal is always accurate. Nor do they need to be for an edge.

The cap-weighted S&P 500 that everyone follows has more large-cap stock exposure than the equal weight. The cap weight hasn’t yet reached the “death cross” level yet.  But it is going to cross soon even if the stock index trends up sharply. We know this because of the length of the lag time in the 50-day moving average. Even big daily gains won’t be enough to stop the downtrend in the 50-day moving average before it crosses below the 200 day moving average.  Each days weight is only 1/50, so it is up against the trend of the other 49 days.

The equal weight S&P 500 has much more exposure to small company stocks. The S&P 600 small-cap index had already achieved a “death cross” when its 50-day moving average crossed below the 200 day recently.

The death cross is considered a bearish indicator that generates a trend following signal to exit or go short when the 50-day moving average drops below 200-day moving average. We last saw it in 2015 and 2016 when it got a lot of media attention. The death cross signals also resulted mostly in whipsaws.

One difference in 2015 and 2016 was the Equal Weight S&P 500 only gave one signal as the cap-weighted whipsawed with two.

Here we can see why… the Equal Weight has more exposure to small-cap stocks and small-cap stock index only generated one signal.

What the death cross 50/200 moving average “death cross” indicator signals is, with a necessary lag, prices have been declining. That part is a fact.

Only time will tell if it accurately signals more price decline, or if prices have reached a low enough level for buying demand. Indicators that generate trend following signals like the 50/200 moving average crossover are often discussed incompletely regarding only their accuracy (probability), but its the mathematical expectation that matters: are the average profits > average losses?

And indicators that generate systematic trend following signals like the 50/200 moving average crossover are often discussed incompletely regarding a single market like stocks instead of applied across broad markets like currency, bonds, and commodities.

If we remove the moving averages from the chart and focus on the upward momentum the last few days, even the equal-weighted index with its “death cross” signal appears to be attempting to trend back up. So, chances are this will be one of the 60% of the time the signal isn’t accurate.

So far, the index is holding the line. Only time will tell, so 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.

 

 

 

Will the stock market hold the line?

The popular U.S. stock market indexes almost formed a potential inverse head and shoulders reversal pattern, however, the right side was met with selling pressure that exceeded enthusiasm to buy. For those who care to observe the price action as it unfolds, I’ll share my observations of what I’m watching for to identify a reversal or continuation of the trend. I don’t necessarily make my tactical trading decisions based on these things, it’s instead market analysis I do for observation of the shifts in supply and demand that ultimately drive trends.

At this point, these stock indexes we use as a proxy for the stock market have reached the October lows as we knew they could.

stock market trend following momentum

The bad news is we’ve continued to see the desire to sell exceed the enthusiasm to buy. When selling pressure is dominant, prices fall.

The good news is the price level has now reached a point were another potential reversal pattern could form; a double bottom reversal. A double bottom reversal is commonly seen when prices reach a prior low and then find enough buying interest to shift the trend from down to up. Such a shift necessarily requires prices to fall to a low enough point that buyers become willing to buy.  For the trend to change; buying demand overwhelms selling pressure. So, the shift involves some combination of the desire to sell becoming exhausted and the desire to buy becoming dominant. Prices trend in the direction of the most asymmetry.

I don’t get caught up in the semantics of the names of patterns, but instead what the formation is showing about the shift in supply and demand. When a potential inverse head and shoulders pattern fails on the right shoulder, the possibility of a double bottom reversal exists, but still needs to be confirmed. For me, the whole point is; in a downtrend (uptrend), no matter what the time frame, I look for signs of a reversal of the trend through a shift in the supply/demand seen in price action. None of them are ever 100% predictive or accurate, it’s always about possible outcomes and observing the trend. It’s always probabilistic, never a sure thing. But, that’s all we need.

We’ll see if the stock indexes can hold the line, or not.

It’s a process, not an event, so we just watch it all unfold.

Let’s see what it does from here.

Have a Happy Thanksgiving!

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.

 

 

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.

 

Divergence in the Advance-Decline Line May be Bullish

With the stock market swinging up and down with the volatility expansion we’ve seen since February many investors are probably wondering which way stocks are going to trend.

Individual investors should be aware of the big picture.

The primary trend has been up since March 2009 with several declines interrupting it along the way. In fact, there have been eight declines more than -10% and three of them were between -15% and -20%. But, none have been over -20%, which is the level most define as a “bear market”. So, this is the longest bull market in U.S. stocks in history.

Many investors may realize that trends cycle up and down and when a trend moves longer or farther than normal, they may be expected to swing the other way longer and farther. For this reason, the intelligent investor is probably on alert for signs of the beginning of a change in the primary trend from a bull market to a bear market.

Market cycles aren’t just the longer primary trends, they are made up of many smaller trends that may be tradeable swings up and down. Avoiding a large bear market isn’t as simple as predicting it and then exiting the stock market until it’s over. We never know for sure in advance when a primary trend shifts from positive to negative and back to positive. In the real world, we focus on shorter time frames and have to deal with the short-term price swings that happen as a trend unfolds.

Despite the recent volatility and the down days, at this point, the U.S. stock market primary trend remains up. We say that because this two-year chart shows higher highs and higher lows. For that to change, we would need to see the stock index decline and stay below the prior lows. Of course, that is a possibility, but those who are following the trends respond to the actual change of trend.

stock market trend following

One positive confirming indicator is improving breadth during the recent swing up from the October low.

The Advance-Decline Line is a breadth indicator that indicates the level participation of the stocks in an index like the S&P 500. For example, a broad advance shows the internal strength that is lifting most boats, which is bullish. A narrow advance would show a  mixed market that is selective instead of broad participation. So far, we’ve seen the S&P 500 Advance-Decline Line make a higher high in the upswing, even though the S&P 500 index itself has declined the past few days.

bullish divergence advance decline line $spx $spy

One of the characteristics of the Advance-Decline Line is that it treats all 500 stocks the same, giving them equal weight. The standard S&P 500 stock index that investors track is a capitalization-weighted index that weights the largest stocks in the index much more heavily. Since the Advance-Decline Line gives each of the 500 stocks equal power, it emphasizes small and mid-cap stocks more. To get a more accurate view of the Advance-Decline Line relative to the stock index, we can use the S&P 500 Equal Weighted Index. I included it below. As we see, the equal-weighted stock index has trended up more similar to the Advance-Decline Line – and both of them made a higher high.

advance decline bullish divergence spx equal weight

We continue to observe a much more volatile market condition than we saw in 2017. That should be no surprise since the CBOE Volatility Index indicates implied volatility has been elevated as we’ve seen this volatility expansion. However, it’s at 20 today, which is its long-term average.

vix volatlity expansion asymmetric asymmetry

Looking back over two years, the next chart shows how much more elevated implied volatility was over last year.

volatility expansion 2018 vix $VIX trading asymmetry asymmetric

Volatility is mean reverting, which means volatility tends to swing from higher states to lower states. Although the VIX long-term average is 20, it rarely stays at that level. Instead, it swings up and down.

2018 has been a volatile year for stocks by any measure, but it may seem even more volatile since 2017 was so quiet.

So far in 2018, the S&P 500 stock index has been down -1% or more on 21 days.

In 2017, stocks only had a -1% or more down day 4 days the whole year.

By that measure, does it make 2018 a volatile year? Or 2017 a calm year?

2016 had 22 days the S&P 500 stock index was down over -1%

2015 had 32 days the S&P 500 stock index was down over -1%

By this measure, 2017 was an unusually calm year for U.S. stocks. 2018 isn’t a lot different than 2015 and 2016.

Individual down days don’t make a trend unless you are a day trader, which we are not. We measure market risk by actual drawdown. Below is a chart of the drawdowns for the stock index year to date. The S&P 500 has declined -10% twice. A -10% within a year is normal, along with a couple of -5% drops. But, two -10% declines in a 12 month period isn’t all that abnormal, either.

stock market drawdown 2018 $SPX $SPX

One thing that may make the price trend swings and volatility seem unusual this year was the lack of it last year. Below is last year, when we didn’t see any drops more than -4%.

stock market volatility drawdown

On January 24, 2018, I said:

I tell ya what… we haven’t seen a drawdown in the popular stock indexes in nearly a year and a half. We would normally see three or four. Those who don’t think that is important will probably be the investors who are dazed when we do see one.

Markets cycle and swing up and down over time, and so does volatility. At this point, we are observing an overall primary uptrend in U.S. stocks but the shorter-trend trend this year has shown us broader swings of +/- 10% or so as volatility has expanded and price swings have spread out.

Despite the down days Friday and today, the short term trend is relatively positive with positive participation as measured by the Advance-Decline Line. Only time will tell how it all plays out 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 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.

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. 

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.

VIX level shows market’s expectation of future volatility

Volatility is a measure of the frequency and magnitude of price swings up and down in a market or stock over a period of time.

  • Lower volatility is when prices are calmer and don’t swing up and down as much.
  • Higher volatility is when price movement spreads out, and prices swing up and down in a wider range.

We can measure volatility using two general methods:

  • Realized Volatility: based on actual historical price data. For example, we can see realized volatility by looking at historical standard deviation or average true range.
  • Implied Volatility: is a measure of expected future volatility that is implied by option prices. For example, the VIX Index is a measure of expected future volatility.

The VIX Index measures the market’s expected future volatility based on options of the stocks in the S&P 500® Index. The VIX Index estimates expected volatility by aggregating the weighted prices of S&P 500 Index put and call options over a range of strike prices.

The last observation I shared of the trend and level of VIX was VIX Trends Up 9th Biggest 1-day Move. I pointed out the VIX level had been very low, and it was an observation of complacency. The VIX spiked up nearly 300% – a volatility expansion. Actually, we could call it a volatility explosion.

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.

Looking at the current level of 12 compared to history going back to its inception in 1993, we observe its level is indeed near its lowest historical low.

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.

 

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.

 

 

 

 

 

 

Emerging Markets Reached a Bear Market Level, or is it a Continuation of a Secular Bear Market?

Emerging Markets Reached a Bear Market Level, or is it a Continuation of a Secular Bear Market?

An emerging market is a country that has some characteristics of a developed market but does not satisfy standards to be termed a developed market.

The MSCI Emerging Markets Index covers more than 800 securities across large and mid-cap size segments and across style and sector segments in 24 emerging markets. The 24 countries in the index represent 10% of world market capitalization.  The Index is available for a number of regions, market segments/sizes and covers approximately 85% of the free float-adjusted market capitalization in each of the 24 countries.

MSCI uses their MSCI Market Classification Framework to classify countries based on economic development, size and liquidity, and market accessibility criteria.

According to MSCI, it includes countries like Brazil, Chile, Colombia, and Mexico in the Americas. emerging markets in Europe, the Middle East, and Africa are countries like Hungary, Poland, Russia, and Turkey. Asia emerging markets are China, India, Korea, and Taiwan.

MSCI Emerging Markets Index ETF ETFs

Now that we have clarified who the emerging markets countries are, let’s take a look at their price trends.

The MSCI Emerging Markets Index is in a bear market territory, down -20% from its high in January. The investment industry defines a “bear market” as a -20% off its recent high, so we’ll go with it.

emerging markets $EEM #EEM $IEMG

This isn’t the first time Emerging Markets have declined -20% or more since 2009. The downtrend 2015 – 2016 was over -30%.

EEM Emerging Markets $EEM

Looking back to 2007, we see the Emerging Markets Index has never recovered to reach its high in September 2007. It’s still down about -24% from the high 11 years ago.

$EEM Emerging Markets ETF ETFs

So, if we define a “bear market” as -20% off its high, the Emerging Markets Index was in a bear market until January this year and has since reversed back into a bear market again. A bear market that lasts 11 years as this one did is called a “secular bear market“.

emerging markets long term trend secular bear market eem $eem

So, we could say: emerging markets have reentered their secular bear market. Or, maybe it’s just a continuation of a secular bear market if we don’t consider the temporary January 2018 breakout above its 2007 high to have ended the ongoing secular bear market.

The bottom line is, emerging markets countries as an index are trending down. They’ve been in a generally non-trending range for the last decade, though there have been many swings up and down along the way.

It is what it is, but you may now wonder; Why? I pointed out in Trend of the International Stock Market one reason International stocks are trending down for U. S. investors is the Dollar has trended up. Currency risk is a significant risk facing investors in International and emerging markets. But that isn’t the only driver of stocks in these emerging markets countries.

My focus is on the direction of the actual price trends. Any guess anyone has about what is driving the trend is just a narrative. Some guesses are better than others as there are specific return drivers that drive trends, but my decisions are made based on what the trend is now and if it’s more probable the direction will continue or reverse.

Why do I care about the trend of emerging markets?

As the portfolio manager of a global tactical investment program, I make tactical trading and investment decisions across world markets including not only U.S. stocks, bonds, commodities, and currencies, but also international stocks and bonds. My global universe includes developed countries as well as frontier markets and emerging markets.

As emerging markets are down -20% off their high, smaller frontier markets are close behind and larger developed countries are also in a downtrend.

International stock ETF ETFs

Less experienced ETF investors and advisors sometimes ask why I include international markets in my universe, because they’ve only seen these non-trending, weak trending, and down-trending periods the last twelve years.

I include these international markets to make my universe global because there have been periods when these markets provide significantly better trends and momentum over the U.S. stock market. For example, the 2003-2007 bull market.

international emerging markets countries trend following momentum

You can probably see how exposure to these markets added significant alpha to my global tactical portfolio prior to 2008. However, you may also notice their trends weren’t without volatility and declines along the way, so it wasn’t as simple as a buy and hold allocation to them. My Global Tactical Rotation® systems rotate between these markets trying to capture their positive trends rather than a fixed allocation to them.

As seen in the chart above, the relative strength of emerging, frontier, and developed countries were significant over domestic stock indexes in the 2003 to 2007 bull market. It was a trend driven by commodities and countries that produce natural resources.

They will have their opportunity again but for now, this trend isn’t our friend.

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.

Global Market Trends, U.S. Dollar, Emerging Markets, Commodities, and Their Changing Correlations

One of the more interesting global macro market trends right now is the direction of the U.S. Dollar and its impact on other markets.

The chart below is the U.S. Dollar trend year-to-date vs. the Emerging Market Index ETF. Emerging Markets are newly industrialized countries whose economies have not yet reached developed status. As the U.S. Dollar index has gained around 5% in 2018, Emerging Markets have trended down over -7%.

EMERGING MARKETS EEM $EEM #EEM DOLLAR TREND FOLLOWING ASYMMETRIC

At the bottom of the chart, I included the correlation coefficient of the trends between the U.S. Dollar and Emerging Markets. A high correlation value is +1, non-correlated is 0, and a completely negative correlation is -1. The value of -0.90 is a negative correlation relationship between them. As the Dollar is trending up, Emerging Markets is trending down. We don’t need a correlation coefficient equation to determine that since it’s clear by looking at their price trends, the value shows just how negative the relationship has been.

Since Emerging Markets are growing countries, you can probably see how changing trends in currency rates can have an impact on them. For example, countries like China, South Korea, and Thailand are Emerging Markets. If those countries are selling their products to Americans who buy them in U.S. Dollars, a rising Dollar relative to their currency makes their things more expensive for Americans.

Correlation is the relationship or connection between two or more things. In investment management, we use it to measure the degree to which two or more securities move in relation to each other. Correlation is probably one of the most misused equations because professional investors seem to rely on it too much.

Correlation isn’t necessarily causation.

Correlations are ever evolving  – they change over time.

One of the most dangerous investment management mistakes is to assume markets that are supposed to trend independently will always be negatively correlated. A grand example is the failure of diversification among markets that are supposed to trend independent to each other to provide downside risk management in a bear market.

In the chart below, we show the % off high U.S. stocks, Emerging Markets, Developed Countries, and Commodities since June 1999. It shows the drawdowns of these markets from their % off price highs. The October 2007 to March 2009 “Financial Crisis” wasn’t the only time expected non-correlations failed. In the “Tech Wreck” from 2000 to 2003 we also observed international stocks, real estate, and commodities all declined together.

global asset allocation diversification failed 2008

Back to the U.S. Dollar…

An observation is to see something. The action or process of observing something carefully in order to gain information.

Insight is the understanding of a specific cause and effect within a specific context.

What is driving the Dollar up?

Ultimately, supply and demand drives the price trend of everything.

  • If there is enough buying enthusiasm – price goes up.
  • If selling pressure overwhelms buying demand – prices fall.

Beyond this simple economic principle, I believe we have certain key drivers of global market returns. It’s things like the direction of interest rates and inflation. For example, with the Fed raising our interest rates in America, our Dollars have a higher yield for foreign investors. If foreign investors were only earning .50% on their Dollars a year ago and now it’s 1.5%, that may motivate them to buy more Dollars.

Because supply and demand ultimately drives the price trend, I focus on the direction and change of direction of price trends themselves. Correlations are only a secondary observation for me. In fact, though the year-to-date correlation between Emerging Markets and the Dollar is negative, I show below these correlations do indeed change over time. However, though it’s oscillating in degree, we observe there is generally a negative correlation between the Dollar and Emerging Markets – it stays below .50.

changing correlation emerging markets dollar

Below we see that an index ETF of Developed Countries like Japan, the United Kingdom, France, and Germany are also demonstrating a negative correlation with the Dollar, but not as much as Emerging Markets. The iShares MSCI EAFE ETF (EFA) is down about -3% year-to-date with a correlation of -63.

dollar correlation with international stocks ETF ETFs EFA EEM

Another asset class that typically shows a negative trend vs. the Dollar is commodities. The commodities index correlation was negative up until May and has since become more connected.

commodities correlation with dollar

Just like price trends, correlations change and evolve over time. Investors shouldn’t expect them to remain intact when they historically show us they don’t.

It’s interesting to observe how markets interact with each other, but their relationships change because there are different return drivers impacting them.

This is why I don’t constrain myself to beliefs that require fixed causations or correlations. I prefer to be more flexible and unconstrained so I can adapt to changing conditions.

Everything is impermanent – nothing lasts forever.

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.

Global Market ETF Trends

Looking at the broad global markets, U.S. stocks are in a positive trend along with the U.S. Dollar. International stocks, commodities, and foreign currency are trending down.

With the directional trends and momentum being in U.S. stocks, though not without volatility, that has been our focus this year.

International stocks including both developed countries $EFA and emerging markets $EEM are trending down so far in 2018 as the U.S. Dollar $UUP is trending up.

The U.S. Dollar $UUP is trending similar to U.S. stocks $SPY in April.

The dollar has an inverse correlation with foreign currency like the Euro.

With the rising dollar $USD, gold $GLD is trending down even more than the Euro currency $FXE.

So, the overall broad observation of global macro picture is clearly a rising U.S. Dollar and U.S. stocks that are diverging from other markets.

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.

Front-running S&P 500 Resistance

The S&P 500 stock index closed just -1% from its all-time high it reached on January 26, 2018, and hasn’t been that high since. It’s been in a drawdown that was as much as -10% and it has taken six months to get back near its high point to break even.

SPY SPX $SPX $SPY S&P 500 STOCK INDEX

Before the madness begins saying “The S&P 500 is at resistance,” I want to point out an observation of the truth. It is one thing to draw a trend line on an index to indicate its direction, quite another to speak of “support” and “resistance” at those levels.

Is the S&P 500 at resistance? 

Depending on which stock charting service or data provider you use, it may appear the S&P 500 ETF (SPY) closed at its prior high. Many market technicians would draw a line like I did below in green and say “the S&P 500 is at resistance.”

S&P 500 stock index at resitance SPY SPX

In technical analysis applied to stock market trends, support and resistance is a concept that the movement of the price of a security will tend to stop and reverse at certain predetermined price levels.

Support is when a price trends down and stalls at a prior low. The reasoning is that investors and traders who didn’t buy the low before (or wish they’d bought more) may have buying interest at that prior low price if it reaches it again.

Resistance is when a price trends up and stalls at a prior high. The reasoning is that investors and traders who didn’t sell the high before (or wish they’d sold short to profit from a price decline) may have the desire to sell at that prior high price if it reaches it again.

Whether everyone trades this way or not, enough may that it becomes a self-fulling prophecy. I believe it works this way on stocks and other securities or markets driven by supply and demand, but an index of stocks?

To assume a market or stock will have support or resistance at some price level (or a derivative of price like a moving average) that hasn’t been reached yet is just a predictive assumption. Support and resistance don’t exist unless it is, which is only known after the fact.

One of the most fascinating logical inconsistencies I see by some technical analysts is the assumption that “support” from buying interest and “resistance” from selling pressure “is” there, already exists, before a price is even reached. Like “SPY will have resistance at $292.” We simply don’t know until the price does indeed reverse after that point is reached.

But, it gets worse.

To believe an index of 500 stocks is hindered by selling pressure at a certain price requires one to believe the price trend is controlled by the index instead of the 500 stocks in it.

Think about that for a moment. Let it sink in. 

  • Do you believe trading the stock index drives the 500 stocks inside the index?

or

  • Do you believe the 500 stocks in the index drive the price of the index?

What you believe is true for you. But, to believe an index of 500 stocks is hindered by selling pressure or buying interest at a certain price requires you believe the price trend is controlled by the index instead of the 500 stocks in it. That’s a significant belief.

To complicate it more. If we want to know the truth, we have to look a little closer.

Is the S&P 500 at resistance? 

As I said, it depends on which stock charting service or data provider we use and how we calculate the data to draw the chart. Recall in the prior chart, I used the SPDRs S&P 500 ETF (SPY) which shows the ETF closed near its prior high. I used Stockcharts.com as the data provider to draw the chart. I’ve been a subscriber of the