Managing money is a lot like playing poker. The difference between amateur and professional gamblers is the understanding of "risk" and how to allocate capital based on the odds of being able to win any given hand. Of course, no matter how smart you are, a gambler, just like an investor, is betting on an estimation of what is likely to happen in the future. Of course, no one really knows what the next draw of the cards will be just as no one really knows what tomorrow will bring in the equity markets. Therefore, my job as a money manager, is to define and understanding the odds of success in order to adequately allocate the precious resources that belong to our clients - their money. Contrary to what the mainstream media pronounces - our job as investors is not to chase market returns trying to beat a random benchmark index. Rather, it is to protect our capital first and allocate it with the least amount of risk possible to maximize our potential reward.
The reality for most investors, who are driven by emotions rather than a logical, disciplined approach to portfolio management, is that when it comes to their portfolio they continually buy into greed and sell into fear. This is, of course, exactly the opposite of what should be done which is why statistics show that 95% of investors lose money over a 10-year period. Considering the damage that has been done to investors during this past decade it has been no wonder that outflows from equity mutual funds continue to set monthly records.
As of today we are extremely close to registering a confirmed "SELL" signal which is our primary indicator to reduce portfolio risk. In order to give you some context for this signal it is important to review our past instructions.
We have been documenting for several months that there was a potential for a large correction in the market of 5-10%. As such we have consistently warned individuals to hold current allocations but not to chase the liquidity driven speculation in the market after we issued our "buy" signal at the end of October, 2011. The markets rally sharply in the first quarter of this year and In March we wrote "The Stretching Of Limits" where we stated: "However, as we have discussed several times recently, these advances, especially when driven by artificial influences, can stretch the markets to extreme limits along with investor's patience. It is this final capitulation where retail investors "throw in the towel" with the belief that the market is not ever going to correct again. This, of course, leads to those poor emotional investing decisions that eventually lead to larger than expected portfolio losses." Of course, this warning was ignored or reprimanded on many blogs as the expectation was that the market would continue rallying as the mainstream media touted the recovery of the economy. However, we have been on the record and very clear that the "recovery" would wane as the effects from the unseasonably warm winter faded.
On April 9th we first wrote about the coming correction in "The Correction Has Started" where we stated,"For the last couple of months we have been writing about the potential for a correction. That correction, until now, has remained elusive for a variety of reasons from the ECB's liquidity injections, psychology, performance chasing and low participation. However, as we have stated previously, 'reversions to the mean,' or moving averages, always occur. It is this simple reality that is continually disregarded by the mainstream chatter that continually leads investors to buy high and sell low." Again, this warning was either disregarded or rebuked entirely by many under the assumption that "this time was different."
On April 23rd we issued a much more dire warning in "Market Cracks Support - Correction Gets Serious" when we specifically wrote: "First, - we now have a SELL signal on a daily basis. This is disappointing but suggests that markets could decline more in the coming weeks ahead. THERE WILL BE RALLIES but they should be SOLD INTO most likely unless the upward trend resumes which will take a move above the previous highs. Secondly, the market is currently on very important support at 1375. IF the market fails at 1375 we will most likely see lower prices in the coming weeks ahead." Yes, you guessed it, this warning was likewise ignored but, unfortunately, the break of support and further decline is exactly what happened.
Lastly, and most importantly, was the recent alert "Initial Sell Signal In - Confirmation Is Likely" which was issued on May 8th. We penned: "The good news is that the market is currently hovering just above support at 1360 with further support at 1350 just below it. This has been the case for the bulk of the current correction and consolidation process. The bad news is that the market has now issued an initial 'sell' signal as of Friday's close which brings our level of alert up sharply.
It is rare that our initial weekly sell signal does not give way to a confirmed sell signal - it can happen, it just does not happen very often. Therefore, we need to pay attention. The market is currently playing out very similarly to 2010 and 2011. Whether that continues is not important - however, with Fed support ending in June and economic numbers weakening the environment is not currently supportive of higher stock prices." As we stated then, and as we see now, the initial gave us warning about what was to come. The market has now broken through those critical support levels.
As you can see this confirming sell signal is not an "out of blue" thing or an emotional trigger. It has been building for months now. As money managers we are interested in longer term investment periods and look for changes in the overall trend of the market. However, we are also looking for indications of when the majority of the gains have been built into the market or when most of the selling has been completed. It is never a perfect exit or entry point but allows us to mitigate the risk of loss to portfolios over time. When managing money for a large base of clients we do not have the luxury of treating portfolios like a "light switch" and moving entirely in or out of the market. Therefore, our methodology is more like that of a "rheostat" approach to dial up and down exposure accordingly.
Confirmed Sell Signal Approaches
This brings us to the current "sell signal" confirmation. There is very little doubt that the confirming sell signal will occur by the end of this week, or, early next week at the latest. Enough deterioration has occurred within the market at this point that it is now just a function of time. With economic data showing signs of deterioration, the seasonal weather tailwind becoming a headwind and the Eurozone struggling to find its footing - there are more than enough catalysts to continue to pressure the markets at this point. These factors combined with the extraction of liquidity as the LTRO's and "Operation Twist" fade or conclude leaves the market with little underlying support.
With the confirming "sell signal" coming into play this changes our strategy from "buying dips" to "selling rallies." The liquidity driven rally in the first three months of the year gave investors very little opportunity to buy dips. However, now the opportunity to sell into a rally will be the opportune time to re-balance portfolios and reduce market related risk. The WEEKLY chart above shows the S&P 500 overlaid with bollinger bands and two basic moving averages. Using technical analysis should not be complicated. In fact, the simpler the signals the better as it reduces the risk of "signal paralysis." Many individuals try to make technical analysis very complicated which tends to lead to information overload and a lack of decision making. Technical analysis is very individualized and specific so it is important to find the method that works for you consistently.
The confirmation of the initial "sell signal"," as we have explained previously, does not mean to immediately start selling holdings. By the time that a sell signal occurs, since we are using weekly rather than daily indicators, the markets are generally very oversold on a daily basis. These short term oversold conditions, even when contained in a longer term downward trend, and ripe for a reflexive bounce. The second chart shows that on a very short term basis the market is already trading at 2-standard deviations below the mean. In the majority of cases once the market has reached this extreme level of selling a temporary reversal is likely.
What To Do On The Reversal
We will want to sell into any reversal that takes us back to previous support levels that have now turned into resistance. Currently, those levels will be 1350, 1360 and 1375ish. Do not get hung up on specific numbers - these are general areas where you want to start raising cash. If the markets are able to rally above those levels we will update our commentary at that time.
The recommended course of actions are:
- Liquidate weak and underperforming positions as the market approaches the 1350 and 1360 levels.
- Rebalance winning positions by taking profits and resizing positions back to original weights at the 1350 and 1360 levels respectively.
- Look for rotation into precious metals as a "safe haven" investment which is currently very oversold.
- Short duration fixed income is still an alternative as rates will likely remain under pressure from the rotation out of stocks.
- Be careful with dividend yielding stocks - while they will likely hold up during a correction they are already overbought in many cases.
- Our call to buy bonds over the past month has played out well. They are currently overbought and extended. Hold current positions but be selective on new additions at this time. Wait for a move in interest rates to 2.2% on the 10-year treasury before aggressively adding more.
- Hold cash for a buying opportunity when the next "buy" signal becomes apparent.
We stated previously that "This correction process, which is playing out very much like last summer, could last from 4-12 weeks depending on many variables. The only thing that we are looking for, as investors and money managers, is the reduction of investment risk so that invested capital has the highest potential risk/reward profile. A larger price correction in the markets or the continued sideways consolidation process will achieve the same goal of working off the extreme overbought conditions that developed during the January through March rally."
It is the psychology of market participants that ultimately drive prices higher and lower as they respond to the external stimuli of the economic, fundamental or political landscape. The one aspect that can not currently be accounted for, which could quickly reverse this analysis, is the introduction of additional stimulative programs by the Fed. While I currently have little doubt that we will see further easing programs - I do not think that they will come about until we see further economic weakness and a more substantial market decline which would give the Fed the "permission" it needs to take action.
When that happens - it will be time to start buying again, however, in order to "buy" something you need to have cash available to buy with. Remember, getting back to "even" is not an investment strategy in the long run.
Disclosure: I am long GLD.