I realise that this may be somewhat confusing given the overriding issues with the economy, the Euro-Zone, the upcoming political debate on raising the debt ceiling and upcoming pressures to corporate profit margins…but the S&P 500 registered a “buy” signal last week. In this past weekend’s newsletter (click here for free email delivery) we stated that “…politics and economics make very poor bedfellows when it comes to portfolio management. As investors we must respond to market action rather than emotional biases. In the famous words of J.M. Keynes; ‘The markets can remain irrational longer than you can remain solvent.'”
Our investment discipline is driven by technical and fundamental analysis – while fundamentals tell us “what” to buy; technical analysis tells us “when” to buy. Think about a game of poker – if we bet “all in” every single hand we are going to wind up broke – quick. However, if we “size” our bets relative to the “risk” of loss on each hand, we can in turn be fairly successful at the game.
Just like playing a game of poker – when managing a portfolio emotional biases can be damaging. Every day investors are bombarded with information which tugs at emotional biases. However, emotional biases are what cause investors to continually make poor investment decisions from buying at the top of the market to selling at the bottom. If you ever wondered what separates really great investors from everyone else; you will find that they all lived by very simple rules that can basically be summed up as follows:
1. Cut your losers short and let winners run
2. Always protect your capital
3. If everybody thinks one thing – do the opposite.
4. Never bet against the trend
5. Sell into greed – Buy into fear.
Yes, it really is that simple. Unfortunately, for the average investor, it is almost impossible to do as emotional biases cause us to make less than optimal decisions about what should be done because the necessary information required for a logical decision is lacking. While the major macro themes that we watch are important – they can take quite some time to play out. For example our 2006 housing bust and 2007 recession calls each took longer substantially longer to occur than expected. However, the technical analysis, which is more of a study of current market psychology, helps us stay on the right side of the trade most of the time. Very importantly, notice I said “most” of the time. No discipline works 100% of time – but the key here is being disciplined. One thing that is true about ALL great investors was their dedication to discipline.
With that said, and after your read our 2012 market outlook, you will see that it can be confusing that while we are concerned about the major macro view; our shorter term technical outlook is much more positive.
Waves Can Belie The Tide
Obviously, stating that there is a “buy” signal in market has generated quite a few questions since our cautious stance that we took last April.
- Does this change our “struggle through” economic scenario? No.
- Does this mean that we are abandoning our 2012 recessionary call? No, not yet.
- Does this change our long term views on the market? Not at all.
So, if nothing has changed then why are you recommending a “buy”? Because in the famous words of Bill Clinton; “What IS…IS.”
First, let’s not get too far ahead of ourselves. Secondly, we are only recommending a small increase at the moment from 40% equity exposure to 50% equity exposure while still overweighting fixed income and cash. Finally, by the time signals are given on a weekly basis, the markets are generally over bought on the short term and are due for either consoldation or pullback. That consolidation or pullback will provide a more optimal entry point. This is why we are recommending scaling into positions rather than jumping into the market. What is very critical is that any pullback in the market does not violate support or reverse the trend.
[Geek Note: Our Global Macro Allocation model is a 60% Equity/40% Bonds and Cash portfolio. Therefore, an allocation of 50% to equities is an 83.3% weighting to equities relative to our maximum allocation target. Therefore, if you are running more aggressive portfolios adjust percentages accordingly]
Think about it this way. If you look at the ocean you will see waves rolling into shore, however, at the same time the tide can be going out. The markets and the economy work much the same way. The market can rally temporarily even as the economy weakens. The underlying stresses to the economy and corporate profitability have not subsided even though the markets are responding to recent positive bumps in the data that have done nothing to change the longer term negative trend.
Currently, after the last bullish wave of the market crashed on the shoreline back in April, the next wave has now risen out of the ocean and is heading towards shore. How long until this wave crests is just a function of time but as our longer term weekly indicator suggests (above), which is fairly slow to move, the market has now turned up from the sell signal issued back in April. While there are shorter term concerns to be aware of, the market is overbought short term, the trend is turning positive. This is something that we do not want to ignore – but also is something that we want to approach cautiously. This is why we recommend waiting for pullbacks that do not violate support to add to existing portfolio holdings.
Rising Risk Profile Confirms
Our composite risk ratio indicator, which is a weighted and smoothed average of volatility, rate of change, bullish versus bearish sentiment and new highs versus lows, has also turned up from historically very bearish sentiment. Furthermore, this turn up in the risk profile, which tends to lead market buy signals (last chart), has now been confirmed by the turn up in our weekly indicators. This lends further credence to an investable opportunity in the markets.
As longer term investors we are not looking to try and “time’ market tops and bottoms but rather determine optimal, lower risk, entry and exit opportunities. What these indicators observe is the overall market psychology and trend. Following indicators, such as these or many others, can help reduce the volatility in portfolios by acting as a “traffic light” signaling when to “stop” or “proceed”. When the light changes from red to green you can either slam your foot on the gas or slowly accelerate.
If you race into the intersection you may well get hit by the car that tried to beat the light from the other direction. Conversely, if you proceed initially with caution, you can then accelerate as you become more convinced the coast is clear. That is the premise that we want to get across here. The “buy” signal is effectively changing our signal from red to green, however, we suggest initially proceeding with caution and become more aggressive as the path ahead becomes more clear.
This change in our weekly signal is a positive development short term for the markets. However, as investors and managers, this really nothing more than going from one stop light to the next. Maybe we will get lucky and catch the next few lights ahead “green” as well. Then again, we may not. Just like when we drive our car we must obey the various signals and warnings – otherwise we will potentially suffer a very negative outcome.
So, while there is a “buy” signal for now, let us not forget that we remain mired in a long term secular bear market. In that environment, as we have seen repeatedly over the last decade, market advances have been met with equally disastrous declines. What causes the next decline, when it occurs, could arise from weakening economics, declining profitability or the next crisis in Europe. There are plenty of inherent risks to choose from – pick one. In the meantime, we suggest proceeding with caution, use consolidations and pullbacks to add exposure and manage the overall risk exposure profile of your portfolio relative to the market.