The markets are throwing one of their little hissy fits. They do that from time to time. The markets are like little kids (think the terrible two and threes), they are very emotional and sometimes not very rational. Temper tantrums can happen at any moment and for many reasons. Sometimes Mr. Market just gets out of the wrong side of the bed and is in a bad mood. As I like to say the bond markets are the adult in the room.
Recently the markets have been in a bad mood. Not terrible holding their breath until they turn red in the face kind of bad, but more of the pouty face followed by a single stomp of the feet kind of bad mood. The recent correction is quite minor. In fact, the price correction of the broader market takes us back about a month in price terms. In a balanced portfolio it likely takes us back about 10 trading days. Nothing to see here yet.
The markets correct in regular fashion in secular (long term) bull runs. It's never a straight line up. How do we know when a correction is the beginning of a new long term secular bear? We don't, well not until it's too late. And remember if you are a long term investor and have a long term time horizon you should not be worried about any market dips along the way, whether those dips are the bumps along the road to retirement or a major correction that reduces your portfolio value by 40 or 50%.
So how often do markets correct in a bull run? And by how much do they typically correct?
Here's the S&P 500 (NYSEARCA:SPY) in the bull run that began in 2003.
And here's the bull run of SPY from 2009 to present.
We can see that the 2003 run had some minor corrections along the way. Perhaps there was more conviction in that bull run? Investors in the current market up-trend are not as committed and appear to be a little more skittish. In fact for such a minor bump in the road the 2014 market dip seems to have many investors on edge. The chatter is somewhat concerned. Many wonder if the market run is the direct result of government money printing, borrowing and manipulation of interest rates. Perhaps the bull run was an illusion? Perhaps the medicine will have more severe consequences than the malady it was attempting to fix. Who knows? Only the future has that answer.
In the 2003-2008 recovery market corrections were limited to the 10% pullback level. In the 2009 to present recovery, corrections have approached the 20% level. So certainly this recent pullback is not even yet approaching the previous tests. If we get towards that 20% mark and more, you might then consider that we are entering a new phase - that is a likely a bear market that would essentially be a continuation of a long term secular bear market that many believe we are currently experiencing.
I am not one who is big on technicals but I could not argue with the evidence in the article "A Simple and Timeless way to Trade the S&P 500". Here is that article, here. The author was shown by his father that a predictable way to manage risk and trade the S&P 500 was to use the 300 day moving average or SMA. When the S&P is above the 300 day he buys, when it is below the 300 day he sells. It is a simple way to measure market sentiment and certainly direction.
Now one will certainly give up gains along the way by missing out on some of the market gains, and will not be in the market reinvesting dividends when the market offers the most long term value in perspective (aka market bottoms). But the exercise will manage risk, keeping you out of the markets for the majority of the long term secular bear markets.
Here's a chart plotting SPY with the 300 SMA, moving through the last two market corrections.
We can see that the 300 day would have got you out before the majority of the carnage. And we can see that it would have put you back in the market for a majority of the gains from 2003 to 2008, and then getting you out before the major market collapse. But again over longer periods this strategy will give up considerable total return.
A reader was kind enough to run some numbers on total return and provide this in the comment section of one of my articles using various MAs ... March 15th 1951, to Friday's close.
Trading rules are: Buy at close if the close is above the MA; sell at close if the close is below the MA. These will miss intra-day prices, which could be beneficial or otherwise, but I assume these factors more or less cancel themselves out. Also same rules apply to every MA tested, so we do have an even playing field. Trading costs and tax not taken into account.
- 55dma 6.36% pa
- 89dma 6.48% pa
- 144dma 6.99% pa
- 223dma 7.75% pa
- 300dma 6.88% pa
Again one would certainly leave a lot of money on the table, but it is a way to manage risk. I am more of a fan of staying invested and using bonds and cash to manage that risk profile. But certainly to each his own.
So how what does the 300 day have to say about today's market?
Well, nothing to sweat so far. But as you can see the moving averages will also send some false alarms. The 300 day would have had you in and out of the market several times during the current 5-year bull run. That could create some serious trading costs and angst.
That said the 300 day again would keep an investor (or trader) out of the major portion of severe market corrections. This may be a useful tool for investors who are perhaps rolling the dice on the last few years of their accumulation phase. It may send a signal that it is time to move to that nice balance of stocks and bonds and cash to manage the drawdown phase of income and assets.
STICK TO THE PLAN!
All said if you are a long term investor, stay the course. The markets will go up and the markets will go down. If these markets are making you nervous and you do need to manage risk, then certainly reduce your equity exposure (accept the potential lower returns over the longer term) and add some bonds. One of the best forms of market insurance is long term Treasuries (NYSEARCA:TLT). Over the last few severe market corrections (and even the modest moves to the downside) TLT has been inversely correlated to the broader markets, that is moving up sharply when the markets are moving down. Here's an article on TLT and market insurance with those very telling charts. Of course an investor can also use the broad based bond index (NYSEARCA:AGG) but that ETF adds more stability to a portfolio than the outright inverse relationship to the stock markets.
Here's the recent history of AGG vs. SPY.
For the longer term, an investor may choose to combine a position weighted to AGG with a sprinkling of TLT for more concentrated or reinforced price protection.
Happy investing and be careful out there.
Disclosure: I am long SPY, DIA, VYM, EFA, EWC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Dale Roberts aka cranky is a Streetwise Coach at ING Direct Mutual Funds. The Streetwise Portfolios offer index-based complete portfolios to Canadians. Dale’s commentary does not constitute investment advice. The opinions and information should only be factored into an investor's overall opinion forming process