Not since 1995 has the S&P 500 not had at least a 10% pullback. Normally, you can count on a 10% pullback within an ongoing bull market to a great time to add funds or bring new accounts online. But 2013 is the year of the relentless rally where 2% pullbacks are new 5% pullback. Extreme bullish investor sentiment which is normally a good barometer of when to ease up on portfolio exposure has been pointless, as previous blog posts have demonstrated.
So, whats going on you ask? Why is this year different from the others and what does it mean going forward?
Markets are clearly being driven higher by the Federal Reserve current policy of Quantitative Easement and its by product of 0% short term interest rates.
Its no coincidence that when the Fed ended QE1 and QE2 markets fell apart with declines of -16% and -19% respectively in 2010 and 2011.
Its fashionable right now to analyze each economic tick (especially the recent positive employment data) to determine when the Fed will end QE3. But the truth is we really don’t have an accurate guess for when that will happen.
Three things we know for sure at the moment:
1. We are in the midst of the strong season for equities and that will last until March 2014.
2. The economy as measured by employment is improving. Contrary to politically biased media outlets job growth is not coming from part time employment. GDP growth in the 3rd quarter was stronger than expected. This is market friendly.
3. Bob Dieli’s Aggregate Spread and RecessionAlert.com are both at benign/miniscule odds of recession. Market friendly again.
My best guess of what will happen? Eventually the Fed must end QE3 and the markets may anticipate this ahead of time by churning nowhere or showing internal deterioration in strength. My thinking is that the Fed will do nothing till at least after congressional budget talks in January but by the time March comes around and temps here begin to melt some snow we should be decreasing our equity exposure in a meaningful way.
A quick update on our current status:
The major market indices are at or near major market highs which will likely be a difficult hurdle to surpass in the near term.
In addition, investor sentiment is extremely positive which has negative implications going forward in stock prices.
To our way of thinking the combination of negative investor sentiment with markets at historical highs implies either a sawtooth churning market with little or no gain or a moderate decline in prices in the near term. We don’t believe at this time that a major market top is playing itself out, we believe based on Ned Davis’s market cycle analysis that a major top is due in the Spring of 2014.
All recession indicators remain in positive territory.
So, we are essentially playing defense for our clients by selling off stocks falling in our ranking systems and raising cash rather than reinvesting on the long side. We have added a significant amount of inverse exchange traded funds that should aid in buffering downside volatility in client portfolios.
Should a decline emerge to the degree that overwhelming positive sentiment is reversed we will reverse our course and liquidate the inverse ETF’s and add new long stock positions for a potential new leg up in the indices that could last to March/April 2014.
Brad Pappas
Investors not satisfied enough with a +23% gain on the S&P 500 they want Ludicrous Speed!
All is not quite copacetic on my stock trading screens, there are two factors that are giving me some angst:
1. The small cap dominated Russell 2000 index is losing relative strength compared to the 100 largest stocks as comprised in the OEX index. For the past couple of weeks my trading screen is green for the Dow and the S&P 500 but negative for the Russell 2000, this is not a good sign. The Russell has been leading for a solid year and while our returns remain strong I’m seeing underlying erosion in the breadth of the market’s never ending advance.
As the chart below reveals the market for small cap stocks is rolling over and could likely be a precursor of a larger market pullback sometime soon. On a positive note: all of the economic timing systems we follow show continued economic growth with miniscule odds of a recession within the next 9 months. Its likely that any pullback, if it occurs will be modest and not the Bear Market variety.
2. Investor Sentiment: There have been very few times in recent memory where my ensemble of sentiment indicators are in the uniform opinion as they are at present. Too much euphoria and not enough fear.
Citi’s Tobias Levkovich in an 11/3 briefing: “The Panic/Euphoria Model is sending a clear warning sign of substantial complacency.”
Jason Goepfert at Sentimentrader.com has in my opinion the most reliable ensemble of investor sentiment measurements and the ones that matter the most are at an extreme.
“Smart Money is clearly becoming more defensive while the infamous “Dumb Money” continues to close their eyes and press the buy button.
On a shorter time scale Sentimentrader.com’s Intermediate term oscillator has shifted to ludicrous speed as well.
What to do now? Time to raise some cash and in certain instances modestly hedge our portfolios. We’re taking a hard look at our existing holdings and curtailing long purchases. We’re very fortunate to have few tax losses to take but we do have several holdings that have been lackluster and are candidates to sell.
We seldom use inverse exchanged traded funds, but in my judgement now is a good time for their consideration. While I may think this market is running on fumes, we only intend to use them in modest amounts since the underlying trend for stocks remains higher and no recession is imminent. Or, just enough to soften the pullback should it emerge.
If you’d like more detailed information please contact me directly.
Be careful out there
Brad Pappas
No positions mentioned
We are very pleased to announce our client portfolio performance returns as of July 31, 2013.
We classify client accounts into two categories: Under 20 Holding and Above 20 Holdings. Above 20 Holdings is our default portfolio system new accounts. “Above 20” implies that there is a minimum of 20 stocks in the portfolio but many portfolios in this category have 30, 40 or more.
RMHI Under 20 Holdings: 27.42%
RMHI Above 20 Holdings: 30.9%
S&P 500: 18.2%
RMHI returns include all fees and expenses.
RMHI is not a mutual fund. We manage private portfolios held at Charles Schwab and Co. on behalf of our clients. Our specialty is managing quantitatively driven portfolios with a socially responsible investing screening process.
We believe the combination of scientifically based, back-tested quantitative style provides a superior alternative to socially responsible mutual funds. You can see for yourself at SocialFunds.com
CNN Money has a Fear and Greed Index which now reads 18%, this is a positive development. I imagine this is due to impending action in Syria. But this is just part of the investing process and to understand how to make the Fear and Greed Index work for you understand that you should be alert and looking for buying opportunities when Fear is prevalent and be cautious when Greed is commonplace.
Our intermediate time frame (under six months) and longer term time frames remain positive.
Background music: Ennophonic by Redlounge Orchestra
The most popular question I frequently hear is: “Your back test results look great, almost too good to be true but do your portfolio designs really working going forward?” Very fair question and if you don’t mind this is a great time to add some legalese “Past results don’t guarantee future results or even that a model devised by man and laptops will actually turn a profit in the future”. You know the drill, a back test can look great but will it work in the future or will it be a flop?
Late last year we took (what we thought) was a brave and potentially embarrassing step by placing three distinct trading models on the quantitative trading platform Collective2.com By doing this we could demonstrate the effectiveness of our systems in real time going forward, rather than relying on hypothetical back-testing. While there is no actual cash behind these C2 portfolios we trade them on the C2 platform as if there were like any other client portfolio.
In addition, if you’re intrigued and curious about our holdings, volatility or turnover C2 is a great place to check us out. You’ll see our winners and alas, our losers. In addition to our holdings, Cs provides a month by month return graph. You’ll also notice in the link below that C2 has given our portfolios a rank which is based on their proprietary ranking system and our rank as of August 24 is 9.95 and the highest possible rank is 10. According to C2 “In general a ranking above 5.0 is good. A rating above 7.0 is excellent.”
(Click on this image to be directed to our C2 accounts)
RMHI/OP III has approximately 30 holdings when fully invested and is designed for investors with over $100,000. It is by default the portfolio management system we employ for new accounts. Its also very scalable where at present we have accounts approaching $2 million in size using RMHI/OP III.
In terms of socially responsible investing, it would be very easy to alter one or two holdings so that the portfolio would meet a Vegan investing criteria.
Year to date 8/23 our C2 account III has returned 34% versus 18% for the S&P 500. Returns include commissions and accounting for slippage. Returns do no include management expenses.
You’ll also see that its possible to subscribe to our models on C2. We don’t encourage C2 subscription hence we keep the monthly cost prohibitive.
If you have any questions you can always call us. Meanwhile Dodgers / Red Sox are starting and it is a Sunday night after all.
Brad
