Over the last several weeks I have been addressing the potential for a reflexive rally from market support. I laid out three possible paths for the rally which I want to review. Let’s step back to March 23rd:
“With the breakdown of the market to the 200-dma, the market is now at a much more critical ‘make or break’ juncture. Here as some points to consider:
- The market triggered a short-term “sell signal” last week with a break of the 75-dma. (bearish)
- The market is “oversold” on a short-term basis which provides fuel for a reflexive bounce. (bullish)
- As I will discuss in a minute, the longer-term uptrend of the market remains intact. (bullish)
- Support held, again, at the rising 200-dma on Friday. (bullish)
- The short-term downtrend of the market continues to gain strength. (bearish)
Considering all those factors, I begin to layout the ‘possible’ paths the market could take from here. I quickly ran into the problem of there being ‘too many’ potential paths the market could take to make a legible chart for discussion purposes. However, the bulk of the paths took some form of the three I have listed below.”
- Option 1: The market regains its bullish underpinnings, the correction concludes and the next leg of the current bull market cycle continues. It will not be a straight line higher of course, but the overall trajectory will be a pattern of rising bottoms as upper resistance levels are met and breached. (20%)
- Option 2: The market, given the current oversold condition, provides for a reflexive bounce to the 100-dma and fails. This is where the majority of the possible paths open up. (50%)
- The market fails at the 100-dma and then resumes the current path of decline violating the current bullish trend and officially starting the next bear market cycle. (40%)
- The market fails at the 100-dma but maintains support at the 200-dma and begins to build a base of support to move higher. (Option 1 or 3) (20%)
- The market fails at the 100-dma, finds support at the 200-dma, makes another rally attempt higher and then fails again resuming the current bearish path lower. (40%)
- Option 3: The market struggles higher to the previous “double top” set in February, retraces back to the 100-dma and then moves higher. (30%)
IMPORTANT NOTE: Regardless, of any potential outcome from Friday’s close, ANY rally back to the 100-dma should be used to reduce equity holdings in portfolios. As noted in the 401k plan manager below, the triggering of coincident ‘sell signals’ and the breach of the consolidation process has reduced equity holdings in the model by 25% which is the first reduction since late 2015.”
Nearly a month later, and we are watching the “pathways” play out very close to our “guess.”
As I stated last week:
“More importantly, we continue to trace out the ‘reflexive rally’ path. However, my guess is we are not likely done with this correctionary process as of yet.
From a very short-term perspective, the backdrop has improved to support a continued reflexive rally next week.“
The problem which now arises is the short-term oversold condition, which supported the idea of a “reflexive rally,” has largely been exhausted. Furthermore, the now declining 50-dma, which has also crossed below the 75 and 100-dma as well, suggests that some variation of “Option 2” noted above is likely.
This is particularly the case as we enter into earnings season where estimates are extraordinarily high which provides a backdrop for disappointment.
Time To Take Some Action
I have noted previously the “mistake” that many investors make is identifying a very “specific” price target to take action. For example, in the chart above, the 100-dma, our previous target, currently resides at roughly at 2698. The mistake often made is to only take action if that specific target is met. More often than not, investors wind up disappointed. As Maxwell Smart used to say: “Missed it by that much.”
For us, technical analysis is a critical component of the overall portfolio management process and carries just as much weight as the fundamental process. As I have often stated:
“Fundamentals tell us WHAT to buy or sell, Technicals tell us WHEN to do it.”
In our methodology and process, technical price points are “neighborhoods” rather than “specific houses.” While a buy/sell target is always identified BEFORE a transaction is made, we will execute when we get into the general “neighborhood.”
Given the recent rally, and overbought conditions, we are using this rally to follow our basic portfolio management rules. As the market approaches the “neighborhood” of the 100-dma we are:
- Selling laggards and raising cash.
- Rebalancing remaining long-equity exposure to comply with portfolio target weightings
- Rebalancing the total allocation model to comply with target exposure levels. (See 401k plan manager below)
As a reminder here are the basic rules to follow.
Step 1) Clean Up Your Portfolio
- Tighten up stop-loss levels to current support levels for each position.
- Take profits in positions that have outperformed during the rally.
- Sell laggards and losers (those that lagged the rally, will lead the decline)
- Raise cash and rebalance portfolios to target weightings.
Step 2) Compare Your Portfolio Allocation To Your Model Allocation.
- Determine areas where exposure needs to be increased or decreased (bonds, cash, equities)
- Determine how many shares need to be bought or sold to rebalance allocation requirements.
- Determine cash requirements for hedging purposes
- Re-examine portfolio to rebalance allocations to adjust for relevant market risk.
- Determine target price levels for each position.
- Determine “stop loss” levels for each position being maintained.
Step 3) Be Ready To Execute
This is just how we do it. However, there ar many ways to manage risk, and portfolios, which are all fine. What separates success and failure is 1) having a strategy to begin with, and; 2) the discipline to adhere to it.
Which brings me to my last point.
8-Reasons To Hold Cash
As I discussed last week on the radio show, in portfolio management you can ONLY have 2-of-3 components of any investment or asset class: Safety, Liquidity & Return. The table below is the matrix of your options.
This is basic. But what about other options?
- Fixed Annuities (Indexed) – safety and return, no liquidity.
- ETF’s – liquidity and return, no safety.
- Mutual Funds – liquidity and return, no safety.
- Real Estate – safety and return, no liquidity.
- Traded REIT’s – liquidity and return, no safety.
- Commodities – liquidity and return, no safety.
- Gold – liquidity and return, no safety.
You get the idea. No matter what you chose to invest in – you can only have 2 of the 3 components. This is an important, and often overlooked, consideration when determining portfolio construction and allocation. The important thing to understand, and what the mainstream media doesn’t tell you, is that “Liquidity” gives you options.
I learned a long time ago that while a “rising tide lifts all boats,” eventually the “tide recedes.” I made one simple adjustment to my portfolio management over the years which has served me well. When risks begin to outweigh the potential for reward, I raise cash.
The great thing about holding extra cash is that if I’m wrong, I simply make the proper adjustments to increase the risk in my portfolios. However, if I am right, I protect investment capital from destruction and spend far less time “getting back to even” and spend more time working towards my long-term investment goals.
Here are my reasons having cash is important.
1) We are not investors, we are speculators. We are buying pieces of paper at one price with an endeavor to eventually sell them at a higher price. This is speculation at its purest form. Therefore, when probabilities outweigh the possibilities, I raise cash.
2) 80% of stocks move in the direction of the market. In other words, if the market is moving in a downtrend, it doesn’t matter how good the company is as most likely it will decline with the overall market.
3) The best traders understand the value of cash. From Jesse Livermore to Gerald Loeb they all believed one thing – “Buy low and Sell High.” If you “Sell High” then you have raised cash. According to Harvard Business Review, since 1886, the US economy has been in a recession or depression 61% of the time. I realize that the stock market does not equal the economy, but they are highly correlated.
4) Roughly 90% of what we’re taught about the stock market is flat out wrong: dollar-cost averaging, buy and hold, buy cheap stocks, always be in the market. The last point has certainly been proven wrong as we have seen two declines of over -50%…just in the last 18-years. Keep in mind, it takes a +100% gain to recover a -50% decline.
5) 80% of individual traders lose money over ANY 10-year period. Why? Investor psychology, emotional biases, lack of capital, etc. Repeated studies by Dalbar prove this over and over again.
6) Raising cash is often a better hedge than shorting. While shorting the market, or a position, to hedge risk in a portfolio is reasonable, it also simply transfers the “risk of being wrong” from one side of the ledge to the other. Cash protects capital. Period. When a new trend, either bullish or bearish, is evident then appropriate investments can be made. In a “bull trend” you should only be neutral or long and in a “bear trend” only neutral or short. When the trend is not evident – cash is the best solution.
7) You can’t “buy low” if you don’t have anything to “buy with.” While the media chastises individuals for holding cash, it should be somewhat evident that by not “selling rich” you do not have the capital with which to “buy cheap.”
8) Cash protects against forced liquidations. One of the biggest problems for Americans currently, according to repeated surveys, is a lack of cash to meet emergencies. Having a cash cushion allows for working with life’s nasty little curves it throws at us from time to time without being forced to liquidate investments at the most inopportune times. Layoffs, employment changes, etc. which are economically driven tend to occur with downturns which coincide with market losses. Having cash allows you to weather the storms.
Importantly, I am not talking about being 100% in cash. I am suggesting that holding higher levels of cash during periods of uncertainty provides both stability and opportunity.
With the fundamental and economic backdrop becoming much more hostile toward investors in the intermediate term, understanding the value of cash as a “hedge” against loss becomes much more important.
Given the length of the current market advance, deteriorating internals, high valuations, and weak economic backdrop; reviewing cash as an asset class in your allocation may make some sense. Chasing yield at any cost has typically not ended well for most.
Of course, since Wall Street does not make fees on investors holding cash, maybe there is another reason they are so adamant that you remain invested all the time.
Markets Are Irrational, Until They’re Not
by Michael Lebowitz, CFA
“Those who cannot remember the past are condemned to repeat it.”- George Santayana
Financial history is strewn with examples of failed investments that were thought to be “no lose” propositions offering riches to those who invest in them. Sometimes these were small one-off cases that did not affect many investors. For example, Pets.com was a star of the late 1990’s tech boom. A Super Bowl commercial, float in the Macy’s Thanksgiving Parade, and a lovable sock-puppet mascot brought the company fame and importantly led to a very successful IPO. Despite the effective marketing campaign and its newfound pie-in-the-sky investors, the company went bankrupt in 2000, and its stock went to zero.
Sometimes these “no-lose” situations are much bigger than Pets.com, rope in many more investors and can affect the entire population. The housing bubble in the early to mid-2000’s, for example, was built on the premise that housing prices only rise. In fact, then Chairman of the Federal Reserve, Ben Bernanke in reply to a question inferring that home prices were in a bubble, stated the following: “Well, I guess I don’t buy your premise. It’s a pretty unlikely possibility. We’ve never had a decline in house prices on a nationwide basis.” Needless to say, the decline in home prices was sharp and nearly bankrupted the financial industry.
Most recently the best and the brightest on Wall Street were pushing strategies that shorted equity volatility (VIX). The promise of steady returns and extremely limited risks was too enticing for many investors to pass up. As shown below, the easy money of the last two years caught up with financial gravity and those in this “no-lose” bet lost it all.
These lessons are not historical stories of interest but provide great reminders. The stock market is grossly overvalued. Despite this fact, most investment professionals and media pundits disregard the real risk that valuations and prices regress back to their historical mean.
Like a high school popularity contest, investors flock to those managers cheerleading the loudest. Meanwhile, those with a grasp of reality and armed with the wisdom of history, warn the masses only to be shunned by the investment world. Prudent investors were also ignored for denying the tech and housing bubbles and for claiming risk would kill short VIX strategies.
The take: ignore the narrative of the day and simply remember that markets are typically irrational but often become rational quicker than you can sell.
Let’s see what happens this week.