How To Know When The Crash Is Over
Summary
- Is the worst over? There are proven leading indicator helps determine that answer.
- It seems almost too obvious a low is in.
- The important thing to keep in mind is that defensive posturing momentum remains intact.
- I do much more than just articles at The Lead-Lag Report: Members get access to model portfolios, regular updates, a chat room, and more. Get started today »
The oldest and strongest emotion of mankind is fear, and the oldest and strongest kind of fear is fear of the unknown. - H. P. Lovecraft
My last article "We May Be In A Crash, And Here's Why" got quite a bit of buzz and attention since publishing it Thursday morning. Some saw the article as a contrarian sign that markets are on the verge of a melt-up and the bottom is in. Others saw the signals I brought up as clear warning signs that things are going to get uglier.
As mentioned before, the objective in my writings is not to create fear or panic. I'm a portfolio manager as well and never want to see things collapse as they did last week even if my clients benefit from it because at the end of the day, I'm still a citizen participating in our economy. But I have to call things as I see them, not based on subjective opinion, but actual proven leading indicators to risk.
On that point, last week is a perfect example of why I prefer to follow unemotional, objective, and non-traditional signals. Members of The Lead-Lag Report every week get risk signals broken down by time frame that help guide a portfolio into either risk-on mode (equity heavy), or risk-off mode (bond heavy). Each one of those signals referenced in the Lead-Lag Report has been thoroughly tested in four award winning white papers I co-authored and which I've become known for over many years of presentations across the country. On January 27, the short-term signal turned to risk-off, and remained that way.
All my indicators do is help to identify what the weather is - the conditions that favor an accident. It's always impossible to know the exact mile marker I might crash my car, but I do know I need to slow down when it's raining. And it has been raining for weeks prior to this shock decline in stocks. The question on everyone's mind of course is whether the worst is over, or if my original thinking (that it's not) will turn out to be true.
As I'm writing this Monday morning, futures are all over the place. As I said Friday after the close on Twitter as markets rallied off the week's lows, this seems almost too obvious a point to consider buying back in.
Every talking head is referencing the Fed and some form of global coordinated central bank action. My problem with this is that it is unclear if central banks can do anything about the very real economic impacts the Coronavirus is starting to have. I was skeptical myself at first. But it is clear that fear of the unknown is going to hit earnings growth.
Now - how do we know when the storm has passed? In the short-term, I'm tracking three primary indicators to help get a sense of when risk-on returns. The first is Utilities. In the 2014 Dow Award winning paper I co-authored, it was shown that Utilities are predictive of risk because their movement tells us a lot about changing growth and inflation expectations. When on a short-term basis Utilities are outperforming, that suggests conditions favor a risk-off period ahead. As a matter of fact, Utilities tend to be leading VIX spikes in advance of them happening - just like what happened last week.
Source: An Intermarket Approach to Beta Rotation
I'd like to see Utilities meaningfully weaken here, combined with Treasuries. As shown in the 2014 NAAIM Founders Award winning white paper, Treasuries also are a key indicator for risk behavior in equity markets. Remember - prior to QE3, the stock market did NOT like a flattening yield curve. Since then, all historical metrics flipped and flattening was seen as bullish. We may be reverting back to an environment where the yield curve's behavior actually does matter for stock investors. A strategy that rotates defensively into Treasuries when long duration is outperforming intermediate in the prior month (risk-off), and goes back to stock when it's the opposite (risk-on) results in meaningful drawdown avoidance historically…just like what we've seen last week.
Source: An Intermarket Approach to Tactical Risk Rotation
So Utilities need to weaken meaningfully, and the yield curve needs to steepen. The final thing I'm watching? One of my old favorites - the bond/stock ratio. This is simply the price of Treasuries (TLT) divided by the S&P 500 (SPY). In corrections and crashes, this ratio spikes. It's been a while since we've seen such substantial risk-off outperformance in Treasuries (reminiscent again of environments pre-QE3), but this needs to also meaningfully turn around to bet on a melt-up after the crash. We aren't there yet.
Interestingly, the ratio is at the December lows level of last year. This may serve as resistance. But if it breaks through, we could see another wave lower in equities as the ratio retraces back to the 2016 highs.
Stay safe all - don't think this is an environment to play hero in. Don't let emotion impact your investing. Follow proven leading indicators, and wait for the cycle to come to you.
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