I realize 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.
