In my opinion, 2012 has been a particularly difficult year for traders and long-term investors as well. In the past, I have likened market movements up and down to the process of navigating an airplane to its ultimate destination. In a high wind situation, we can quickly be blown further off course than normal and in rapid fashion.
We may set out from Dallas heading to New York City and, after a short time, find that cross winds have shifted our flight path and we are now heading toward Minneapolis.
When we realize that we are off course, we correct our heading, but inevitably, we under correct or over correct. It is a zigzag process of going too far off course in one direction and then correcting and going too far the other direction and then correcting again. We eventually arrive at our destination, but there is a lot more work involved in a high cross wind environment.
That is how I see 2012. Cross winds have resulted in rapid and dramatic overshoot in both directions. Perhaps by year end, we are going to reach our destination as planned, but it has been a bumpy ride. We started out the year on the S&P 500 at 1272 and we closed yesterday at 1351 - a gain year to date of 79 points. That represents a 6% gain for the year through November 15 - a gain well within the range of normal.
How we got here is not so normal. The cross winds were numerous and constantly shifting. Using January 3 as the start point, we rallied 12%, sold off 12%, rallied 15% and sold off 7% through November 15. I have argued that markets are extremely irrational in the short term, but surprisingly, the marketplace gets it right over the longer term. I don't think an argument can be made for the market being up 6% at the end of the year, but if we closed right here, I would certainly say that the year-on-year gain of 6% is not out of the range one would expect.
The emotional roller coaster that has driven the markets this year involves a number of cross winds. We had what one would consider at least a mini market collapse in 2011 after the debt ceiling debacle that resulted in the "Super Committee's" failure to agree on specific spending cuts in exchange for an agreement on a debt ceiling hike. We ended up with across the board spending cuts - "sequestration cuts" - and a few days later, Standard and Poor's issued the nation's first credit downgrade due in large part to a dysfunctional Congress who couldn't seem to get their act together.
We put in a low in October, 2011 of 1098 off the credit downgrade. Was the 20% sell off from the high justified? In retrospect, probably not, as the world didn't come to an end. After all, the Fed still had our back, and corporate profits built on the back of massive fiscal stimulus and cost cuts were strong.
As it dawned on us that the world wouldn't end with the credit downgrade, we began the climb from the October lows as I thought we would. We ended up rallying 30% off the lows, putting in a high in April of 2012. Was a 30% rally justified? No way, in my opinion. The world certainly didn't end, but we still had a lot of problems. My simple logic was that the rate of ascent was much too fast and unsustainable. I was not that uncomfortable with a 12% gain for the year, but it was April - not the end of the year.
In other words, we went way too far and way too fast and a pullback was in store. I deduced that we would correct the overbought situation and then move higher going into the end of the year. I expected the year to finish out somewhere in the range of the April highs.
What I didn't expect was a 12% pullback. We effectively erased all our gains for the year by the first part of June. That is where my brain circuits started to go haywire. Deficit spending and massive debt accumulation was a negative. Obamacare and the impact to businesses and the potential for unemployment spiking higher was weighing on the markets. Nevertheless, we had pulled back to an oversold area, and I was sure we would move back to the highs.
The Supreme Court was considering the Obamacare case, and I was certain the Court would find the Act unconstitutional and therefore, it would be good for the markets. I had bought the selloff and felt confident of the Supreme Court decision. The ruling was a shock to me and others. The market sold off hard when the Supreme Court announced that it found the Act constitutional based on treating the cost as a tax.
That same day after selling off hard, the market reversed direction when Angela Merkel walked out of a meeting with Euro leaders - the implication was that Germany's conservative stance had been put on the back burner. The euro rallied and pulled equities higher, and the rally that had started on June 4 continued.
The market this year has been one of moving from one crisis to another and one solution to the crisis after another. The summer rally was propelled by expectation of more quantitative easing. By the time QE3 was announced, the market had already priced in even the most optimistic outcome from QE3, and we immediately started lower, continuing to where we are today.
I will admit that I have struggled with the markets as I suspect many have, but what is particularly aggravating to me is that I didn't have to do that. The 2012 market was just the kind of market that is suited to a rule-based strategy. I wrote about a strategy I developed years ago in The Era Of Buy And Hold Is Over Using Trade Structure To Play The Swings.
The rules for the strategy are set forth in that article and clarified in the comments section for those who are interested, and I am not going to repeat them here. As a side note, one of my readers back tested the strategy and provides a little independent validation. He graciously shared the results in the comment section of the article. His back test results generated a 4.6:1 profit/loss ratio and a 70% win rate over approximately 2 years. The chart below was used in that article:
I have a number of readers continue to tell me that I can't predict market swings, and therefore a "buy and hold" strategy is much better. On September 18, just a few days after the much awaited QE3, I recommended going short the market. The following is a quote from The Era Of Buy And Hold Is Over - Using Trade Structure To Play The Swings:
As luck would have it the results as of September 18, 2012 using the strategy are pretty much the same results one would have achieved by buying the close on January 3, 2012 and simply holding the trade. If you would have done that you would have realized a gain through September 18, of $188.60 - pretty much a wash on the two approaches.
What is significant going forward is where we end the year at on the S&P. Under the strategy I propose the sell stop on September 18, 2012, is $1403. Assuming the pattern continues to move between the high end of the band and the low end of the band the S&P will work back to 1273 by year-end. What that means is that I would short the S&P at 1403.00 and if the market does move back to the lower end of the band the strategy proposed here would yield another $130.00 bringing total profits to $276.36. Compare that with a buy and hold strategy, which would end up the year at a $2.10 loss.
Let's take a look at what has happened to see if I can predict the swings. The chart below is the updated version of the chart reflected in my September 18 article:
Trade Results Table
As it turned out, the market turned lower the day before I wrote the September 18 article, but the lag caused the Mean value to continue to climb as the market was rolling over and turning down. The result was that the plus one standard deviation sell stop moved from 1403 to 1433. This shift also raised the minus 2 standard deviation band higher from 1273 to 1334. We closed on November 15 at 1351, leaving us with a year to date profit of 254.
Assuming we do move to the minus 2 standard deviation band, we will add another 17 to the 254, bringing year-to-date profits to 271. I predicted year-to-date profits at 276, so I missed by 5 points unless the minus 2 standard deviation band moves lower as well, which it necessarily must, as the mean value has flattened out and is about to turn down.
Sorry for the lack of precision here, but a 5 point miss - which may not occur - is pretty good by anyone's standards. I admit that I have been influenced by the fundamentals throughout the year, and haven't done as well as the results above. To my own chagrin, I have seen fiscal and monetary policy as major negatives and resisted following the bull side of the trade during the QE3 euphoria rally, even though the strategy told me I should be long the market.
I have used the strategy reflected here for years, and it works. Our minds are, at times, our worst enemy. I am a reasonably good fundamental analyst. I understand things others miss, and that does not always work to my benefit. As traders became irrationally euphoric over the prospects of QE3, I continued to offer a lot of fundamental data that suggested that regardless of QE3, we were going lower.
The monetary and fiscal policy initiatives we have employed since the recession are simply not working to rejuvenate the economy. I know that, and it biased my trade decisions. Others - perhaps less informed - did not know that, and it biased their trade decisions as well. The truth is there were a lot more ill-informed traders driving the market higher than well-informed traders pushing the market lower.
As we move into the end of the year, the fundamentals are finally coming into play. As I said at the start of this article, in the short term, the markets do veer off course, but in the long term, the markets always get it right. Although I don't discount the possibility of a major selloff that could test the 2011 lows by year end, my guess is we end the year a little lower than where we started. That corresponds well with my fundamental analysis and coincidentally corresponds well with my trading model prediction.
Additional disclosure: I am short a group of tech stocks, financial stocks and crude oil. I am long the VIX.