As I’ve mentioned in an earlier post: Show me a portfolio manager with strong convictions and I’ll show you a manager with a spotty record.
We are always very cautious when it comes to hedging our managed portfolios with inverse exchange traded funds when there is no recession in sight. Flexibility is key. Over the past month we’ve been expecting climactic selling to occur in October which we believe was fully realized by mid month. The headlines were quite scary with the threat of a worldwide spread of Ebola and concerns about the US economy in the face of the end of Quantitative Easing and the European economies degrading into recession.
“Hedging” is the purchase of securities that move inverse to the stock market. Its one method of protecting your capital during periods of higher than average risk and volatility. Protecting your capital or principal is essential for the long term success of any investor but oddly, is almost unheard of in the mutual fund and in most private portfolio management firms where “buy and hold” regardless of market environment is the mantra. Without hedging or any sort of risk control your principal is at risk of a nauseating roller coaster ride that should only be ridden by an investment masochist.
At present, it would appear that the concerns regarding Ebola and the US moving to recession were quite overblown but they served the purpose of providing the necessary catalyst for a market sell-off and creating the necessary atmosphere of fear for a potential rally. Fear is an essential factor in the creation of market selling and market bottoms but the transition from bearish market action to bullish can occur in a matter of just a few hours or even minutes as was the case on October 15th and 16th. On those dates the stock market plunged and Treasury bond prices soared to such an astonishing degree that could only be viewed as climactic. “Climactic” is viewed in market terms as the end of the move, an absolute blow-out of selling or buying that typically ends a market trend.
During these days of mid October we sold all of our hedges and Treasury bond holdings and reverted back to a standard fully invested in equities status. Had we been as dogmatic as typically seen with the talking heads on CNBC we would have missed the reflex market rally to the end of October. We don’t use any sort of quantitative based market model to make these quick decisions, these decisions are quickly made with the benefit of decades of experience and study of bear market behavior. We also knew that the chances of recession were nil and that any major weakness was in fact, an opportunity to buy. We also knew that a major seasonal and yearly economic cycle wave was about to commence, and staying hedged would probably come back to bite us badly.
US markets have experienced a textbook V-shaped recovery which is not too surprising considering that the risks of a US recession are non-existent for the time being. Without a recession, market weakness should be viewed as a buying opportunity.
But now lets take a look at a chart we showed you in January. Below is the cycle forecast for 2014. Notice the peak in the Spring to be followed by an extended period of weakness ending in October. This chart proved to be quite accurate for the small stock Russell 2000 but the larger stock Standard and Poor’s 500 was relatively defiant and did not endure the Spring to October weakness.
October 2014 and beyond: From our point of view the investing year of 2015 started at the market bottom two weeks ago. As you can see from the chart above market cycles bottom in mid-October and begin a strong and prolonged rally that typically endures into what would be 2016.
To be honest, I can’t give you a concise reason for why cycles work. It used to be that 4-year cycles were closely aligned with US monetary policy but there is no longer a direct correlation to actions by the Fed. But in my experience they tend to be relatively accurate more often than not and we continue to give them credence until proven otherwise.
Summary: Its our belief that the rocky patch for equities we expected in 2014 has passed and a new leg up for US equities could be on the horizon. At present the chances for a peak in the US economic cycle in 2015 appears about nil. Ebola appears to have been a short term scare in the United States and other developed countries where the rule of law, medical care and lack of political corruption are present.
There are no cases where a recession in Europe pulled down the US economy into a recession as well.
The small stock Russell 2000 appears to have regained its footing on a relative basis to the S&P 500 index, in other words small stocks may have started to stabilize which is necessary if they’re going to being their traditional out-performance of larger stocks in November through January.
While we all reserve the right to gripe about the markets, the economy and financial inequalities, the path of least resistance for stocks does appear higher. But keep in mind that this market rally dates back to 2009 and is rather mature. There are no great deals out there anymore and investor’s search for yield in the absence of any real return on CD’s or Treasuries has reached the absurd. Fixed income or long term Treasuries might be the single most overvalued asset class today.
Be careful out there.
Brad Pappas