Not a market for investors, but remains a great trading market for balancing risk with the use of SQQQ and TZA. We’ve just closed out this latest round of hedging and will watch and wait for a bounce to emerge in the indices before we’ll likely have another go round with our hedges.
The markets are being led down by the Nasdaq and Small Caps which were the leaders in 2013 but I do wonder how long the S&P 500 can hold up. The strength in large caps is promising as we suspect that mid and large caps will emerge as the new leadership.
As a reflection of our anticipation of mid and large cap dominance going forward we continue to liquidate what few small caps we have. While we have no intention of abandoning small caps completely they will be a much smaller percentage of assets going forward.
With thanks to our development partners in London we will begin to slowly integrate our mid and large cap systems into specific client portfolios during future market weakness. Our first and so far only addition was made this morning with purchases of Automated Data Processing ADP.
Be careful out there
Brad
Long ADP
This may not be a good market for investors but its a fine one for traders. Over the past months we have maintained a cautious tone with the expectation of a potential April top for US equities. While we don’t expect anything dramatic in terms of a sell-off, the selling could be substantial at times as the markets begin to flush out newbie momentum investors or those who need a refresher course in market risk.
As for this being a fine time for nimble traders, this has been the case especially in the Nasdaq and small cap sectors as identified by symbols QQQ and IWM, both of which have rolled over and are leading on the downside. We’ve been able (so far) to capitalize on the the weakness by trading the SQQQ and the TZA as both markets appear to be in a “two steps down and one step up” mode.
Eventually this period will pass and fear will be reinstated as a common investor emotion which will probably lead to a strong second half of 2014. At present, we see no signs of recession and weak markets within growing economies can happen but they’re typically shallower and briefer than recession based bear markets. So, assuming the markets remain with a downward bias into the Summer, this will likely lead to an excellent entry point later this year.
Notice the divergence between the stodgy S&P 500 and the NASDAQ and IWM. This kind of behavior leads me to suspect that the outpeformance in the small caps may potentially be over which is one why we’re expecting to lean heavily on Mid Caps when we eventually move to fully invested.
So far we have avoided shorting the SPY via inverse exchanged traded funds, we’re respecting the market strength.
We continue to opportunistically trade the SQQQ, the inverse QQQ ETF as this market shows a bearish trend. I’d expect to sell the SQQQ in the event the QQQ revisits $84.
We are trading the TZA which is an inverse exchange traded fund that mirrors the IWM which is a proxy for the small cap stock market. We expect to sell the TZA if the IWM moves below $111.
To sum it up: For the time being, this is not a market for investors but for traders. This too shall pass.
Brad Pappas
Long TZA and SQQQ
20 minutes to spare and time to update our blog.
On February 3rd when the Dow was down 300 points we sold our short positions in the Emerging Markets (EDZ) and Russell 2000 (TZA) as well as closing out our position in the 20+ leveraged Treasury Bond ETF (TMF) for some nice short term gains. Those gains covered losses in what remaining equities we had and actually resulted in a net positive day for us.
And to defy a client who in jest wondered if I was practicing “voodoo” in their accounts by having their net worth rise on a big down day (Being Irish automatically excludes any Voodoo ability) I went back to the TZA hoping for continued downside in US Markets, it didn’t happen and we incurred a 7% loss, so there.
What have we done lately? We continue to hold on to our municipal and taxable bond funds which account for approximately 40% of our assets. I still believe, lurking out there in the future is a market sell off in the 10% to 20% range. Eventually the S&P 500 has to touch the 200 day moving average which it hasn’t done since 2012. 2013 is the exception to the rule when it comes to revisiting the 200 day moving average.
However, new Fed chair Janet Yellen provided positive testimony to Congress about the state of the US economy and that stopped the selling last week.
We will be entering a short but strong seasonal period that should last into April. Hence we took some cash off the sideline and added to our minimal stock positions. But at most we’re only 50% invested in equities and 40% in bond funds, the remaining 10% is in cash.
Emerging markets have stabilized and that is providing strength to US large/multinational stocks which do quite a bit of business overseas. This large stock strength is coming at some expense to the type of small stocks we prefer causing a bit of lag in our accounts versus the indices. This is likely a short term phenomena.
While a market sell off can occur at most any time, seasonality still points to a peak in US stock prices in March/April 2014 where we can expect an approximate 6 months of net weakness. So caution is still advised.
There will a very good fat pitch coming to us in the September/October time frame and that’s the pitch we want to be ready for.
Brad
No positions
RMHI and OP clients are very well positioned in light of the falling stock prices in the US and abroad, especially in emerging markets (EM).
As mentioned previously we thought risk could happen fast once the new year was upon us but even I’m surprised by the ripple effects of the FOMC’s taper decisions. We had not anticipated that it would throw the emerging markets (Brazil, Russia, China and Asia, India, Turkey, New Zealand) into turmoil. Turkey, New Zealand, India and Brazil all have central banks that are raising interest rates sharply to stabilize their currencies, which will penalize their growth longer term. If we add a slowing growth rate in China, it only compounds the problems. This is a very bearish environment for EM stocks.
At the start of the year the consensus was that interest rates would rise. We took the other side of that argument thinking that the consensus would be wrong…and were they ever. Who would have thought as recently as 10 days ago that not only were rates not going to rise but that the EM banks would be tightening credit and with investors fleeing stocks and turning to Treasury bonds we’d have a full scale rally in Treasury Bonds?
As it stands as of today 1/29/2014 our largest 5 holdings are:
1. Direxion ETF Emerging Markets 3x Bear symbol “EDZ”: This exchange traded fund or ETF will rise in price if the Ishares Emerging Markets Index “EEM” falls. My thought was that the EDZ would be a much better hedge against any residual stock positions we retain since the emerging markets is facing a real threat while the US is merely experiencing slowing growth. In other words I felt there was a better chance the EDZ could rise sharply than a US based inverse ETF.
2. Pimco Municipal Income Fund “PMF”: stable and wonderfully boring in a volatile world with a locked in 7% tax free yield based on our purchase prices.
3. Nuveen Enhanced Municipal Fund “NEV: see above for PMF
4. Blackrock Municipal Income Trust “BFK”: see PMF and EIV
5. Direxion 20+ Year Treasury Bull 3x: “TMF” This is a leverage ETF we bought a few weeks ago when we started to see an emerging rally in 20 and 30 year Treasuries which was based on the extreme negative sentiment regarding bonds at the end of the year. So far, so good. With the worlds economies slowing and markets retreating T-bonds are a logical place for investors who want a safe haven.
Long all positions mentioned.
Be careful out there,
Brad Pappas
As a private investment management firm we’re not restrained from reducing risk when we see fit. Perhaps its an old Irish Catholic bromide that “No good will come of this” attitude rears its head every time I see and excessive or parabolic moves in markets, asset classes or stocks. Parabolic Markets = The End is Near.
We’ve seen these kind of parabolic moves before: Treasury Bonds in 2012, Gold in 2011, the NASDAQ in 2000-2001. In 2013 we took profits in parabolic stocks such as FU, SGOC, FONR. All three gave back their gains and in the case of FU – the company has been delisted with balance sheet issues.
Do you remember 1987? Big hair and even bigger shoulder pads. Celtics and Lakers along with team oriented basketball. Duran Duran and endless amounts of Phil Collins and a parabolic stock market that never pulled back until the music ended on October 19th where the Dow Jones Industrial Average dropped 22.6% in a single day.
Some but not all of the main culprits of the crash are evident now and while market cycles never entirely repeat themselves, they can echo the movements of the past. I believe there is a good chance that we’ll see a short and sharp market sell off sometime soon to alleviate the extreme investor bullish psychology.
What the markets have going for themselves for the time being is a nil chance for a recession anytime soon. Most major Bear Markets occurs as the economy is heading into recession and that is not the case. So, what I’m expecting is a brief but potentially painful market correction of short duration that could commence at any time.
Most market pullbacks can largely be ignored as we can’t compensate for all of them. My focus is to identify the environments where major pullbacks are likely. Pullbacks of the size that they cannot be ignored, in the range of 20% to 30% or more.
The biggest hurdle for the markets going forward is the issue of extreme investor bullish sentiment. For those unaware, “sentiment” is an inverse indicator. This means when investors (both pro’s and amateurs) are extremely bullish its a negative and high risk for the markets. When those investors are extremely negative its a positive and low risk environment for stocks.
I recently came across a very good paper discussing the relationship between sentiment and stock returns: “Investor Sentiment and The Cross Section of Stock Returns” by Malcolm Baker and Jeffrey Wurgler. Published by National Bureau of Economic Research.
Page 5: “When sentiment is low (investors are bearish) subsequent returns are higher on young stocks than older stocks, high return volatility than low-return volatility stocks, unprofitable stocks than profitable ones, and non payers rather than dividend payers. When sentiment is high (as it is now), these patterns completely reverse. In other words, several characteristics that were not known to have and do not have any unconditional predictive power actually reveal sign-flip patterns, in the predicted directions when one conditions on sentiment.”
In plain English, this means that the stocks that were so profitable for us when investors were fearful and negative can turn quickly and decline sharply in price when investors are too giddy and positive.
The chart below will give you an idea of how extreme sentiment is at present and where it ranks in years past, and a look to what happened going forward. Remembering the “echo” Investors Intelligence Bulls minus Bear is the highest since February 1987.
But what contributed to this extreme positive sentiment? Here are some culprits:
2013 was the first time since 1995 where the S&P 500 Index never declined to touch its 200-day moving average.
So as of the end of the year the S&P 500 would have to decline at minimum 10% to even touch the present 200-day moving average. This also means that select portfolios with less than 500 stocks would likely fall greater than 10%, 20% would not be surprising.
In December the Federal Reserve announced they will be “tapering” Quantitative Easing. The chart below shows the previous attempts to wean the economy off of QE and subsequent market reaction. Note: Once difference to this round of tapering is that the economy is not quite as weak as before which may account for no immediate market sell off.
Lastly, we have the Presidential Cycle. The Presidential Cycle is a way of looking at the equity markets through the lens of 4 year Presidential term. The Presidential Cycle is closely related to the business cycle which is largely controlled by the Federal Reserve. The second year of the Presidential term is uncharacteristically weak relative to the other three years. Don’t let the mean rate of return fool you, there have been many second years where at some point the major market indices were down in excess of 10%.
For the past few weeks we’ve become increasingly more cautious as investor enthusiasm has reached euphoric levels. The irony of this is that Jason at Sentimentrader.com has published a study that euphoric investor enthusiasm doesn’t always lead to weakness, it frequently can create a short term top followed by churning market action before resumption of the rally. Churning action is not bad at all and in the past week we’ve seen two of our holdings make extraordinary leaps: FONR catapulted from $11 to $19 and today SGOCO Group rose 47% in a single day.
Combined with this is the fact that we are in the strongest season of the year for stocks. This evening I ran a study dating from 1999 to 2013 where I measured the rate of return for our models from November 19 to March 31 of the following year.
There were 12 time periods measured and I excluded 2008 and 2009 from consideration due to recession. Note there was a recession in 2001-2002 period as well but small cap value defied the recession and posted strong gains. The results are a combination of both real time and hypothetical data.
Average gain November 19 thru March 31 was 18.91% including all fees and expenses.
Low return was 5%. The high return was 30%. Median 17%.
There were no negative returns.
The markets reluctance to sell-off despite high sentiment readings but with strong seasonal strength gives me the sense that holding inverse exchange traded funds may not work this time and they were sold for a small loss.
Brad Pappas
Long FONR and SGOC
