During May of this year a meme spread through the financial world about the under performance of the Dow Jones Transportation Index (DJTA) in relation to the Dow Jones Industrial Index (DJIA). Everyone was talking about the Dow Theory non-confirmation and what it meant for the markets. Today DJTA is still under performing, but the crowd isn’t talking about it. They’ve moved on. It doesn’t matter anymore. Why? Group think. Group think is common in the financial markets (and society in general). An idea that seems reasonable often finds wide support regardless of its merit due to market participants repeating the meme without taking the time to do some independent research or even think about it. When dealing with stock market memes it doesn’t matter if it’s correct it only matters how many other people think it’s correct. Group think moves markets. An example of group think came in early 2013 when a study stating low volatility stocks out perform high beta stocks was widely circulated. This study was repeated
My core market health indicators weren’t impressed by this week’s rally. All of them fell in the face of a rising S&P 500 Index (SPX). This isn’t an encouraging trend. During the month of July as the market traded sideways in a 5% range my core indicator categories have broken down one after another. This week my measures of market strength fell below zero which is changing the allocations in the core portfolios. The new allocations are as follows. Long / Cash portfolio: 20% L0ng and 80% Cash Long / Short portfolio: 60% Long and 40% Short the S&P 500 Index Below is a chart with the portfolio changes over the past year. Green is adding exposure / reducing a hedge. Yellow represents adding a hedge or raising cash. Red represents a market risk warning where I use an aggressive hedge (with put options or a product that benefits from rising volatility). Fortunately price hasn’t broken yet and as a result market participants are comfortable keeping core measures of risk
Over the past week most of my core market health indicators fell. Most notable is my measures of the economy which have gone negative. As a result, the core portfolios are adding a larger hedge or raising cash. Below are the current core portfolio allocations. Long / Cash: Long 40% – Cash 60% Long / Short: Long 70% – Short the S&P 500 Index 30% My market risk indicator currently has two of four indicators warning, but the other two a long way away from a signal. It appears that people aren’t too concerned about the current dip. In the absence of any risk event (i.e. Greece, Ebola, etc.) my risk indicator generally won’t signal without serious price deterioration. As a result, the Volatility Hedge stays long during “normal” consolidation periods. It is currently 100% long and I expect it to stay that way unless we see a steeper decline ensue. Below is a chart with changes to the core portfolio allocations over the past year. Green lines represent adding
I’m starting to see signs that market participants are abandoning their losers and pressing their shorts. When this occurs near all time highs it often means some pain is ahead for the major indexes. Here are some charts that serve as examples. First is NYSE New Highs / Lows. New lows have now risen above the point when the S&P 500 Index (SPX) was making lows in early July and last December. This indicates market participants aren’t bottom fishing. Instead, they’re abandoning positions that are causing too much pain. Another point of interest in this chart is that NYSE didn’t recover much from both June and July lows. This type of divergence from SPX is troubling. The Russell 2000 Index (RUT) and Dow Jones Industrial Index (DJIA) are also showing negative divergences from SPX. Next is a chart that compares a short of the S&P 500 Index (SH) and an actively managed bear fund (HDGE). SH has fallen to new lows while HDGE is holding up. This indicates that traders
Over the past week most of my core market health indicators improved. However, none of them moved enough to change the core portfolio allocations. This is a little discouraging given the fact that the S&P 500 Index (SPX) has rallied sharply. The overall picture I’m seeing is a thinning market that is trying to recover. Which is in line with a modest hedge or a moderate amount of cash for a cautious investor. Aggressive investors would be more comfortable riding out dips unless they are accompanied by high risk (Volatility Hedge). Below are the current allocations. Long / Cash portfolio: Long 60% – Cash 40% Long / Short portfolio: Long 80% – Short 20% Volatility Hedge: 100% Long The percent of stocks in SPX that are above their 200 day moving average has recovered from 50% back to 60%. This is a small positive sign that indicates some value buying is occurring (rather than dumping stocks as they break below their 200 dma). Unfortunately, the market has 15% fewer bullish
I’m seeing several indications of weakness in the long term trend, but at the same time I’m seeing a lot of indicators that continue to show strength. It appears as if the battle for the long term trend has started. The first sign of weakness comes from monthly MACD for the S&P 500 Index (SPX). It has been rolling over since late last year and finally had a bearish cross in April. Momentum for SPX has been falling, but it is still at healthy levels. So here we’ve got two measures of momentum where one is bearish and the other is bullish. The next conflict comes from a point and figure chart for SPX. It recently broke its uptrend line that was put in place in late 2012. This created a new down trend and is considered bearish. Price has since recovered and is now only a few points away from breaking the down trend. If SPX can get above 2020 a new uptrend line will start and turn SPX
We end this week in a critical situation. My core indicators were all damaged during the high volatility moves both up and down this week. Core measures of risk and trend have now gone negative. The measures of the economy are close to going negative and market quality and strength aren’t far behind. As a result the core portfolios are raising cash and or adding a hedge. The new core allocations are as follows. Long / Cash: 60% Long and 40% Cash Long / Short: 80% Long stocks I believe will out perform in an uptrend — 20% short the S&P 500 Index (SPX) My market risk indicator hasn’t signaled yet so the volatility hedge will remain 100% Long. So, what’s an investor to do? Follow the core portfolios or the volatility hedged portfolio? The answer lies in your risk tolerance. The volatility hedged portfolio is designed to ride out most dips in the market and only hedge when the odds for a steep decline rise. The core portfolios are
All of my core market health indicators fell this week, but none of them fell enough to change our core portfolio allocations. All of the portfolios are still 100% long. One thing of note is that my measures risk, economy, and trend are all very close to going negative. I suspect the market will need to rally next week or the core portfolio allocations will change by raising cash and/or adding some shorts. Have a good holiday weekend everyone.
Over the past few days various measures of breadth have show quite a bit of weakness. As I noted in this post, large market declines come when breadth is already weak. With such weak readings the odds have increased that this decline will be 10% or more. Below are some breadth examples. First is NYSE Advance/Declines. They led the current decline in the S&P 500 Index (SPX). Small caps are especially sensitive to this condition. Next is the Bullish Percent Index (BPSPX). It currently has less than 60% of the stocks in SPX with bullish point and figure charts. This indicates a significant number of stocks in down trends. Last is the percent of stocks in SPX that are below their 200 day moving average. Nearly 50% of SPX stocks are below their 200 dma. With all three measures of breadth showing significant weakness, a signal from my market risk indicator should be taken seriously.
Here are a couple of things that haven’t happened since late 2012. First is a downtrend in the Dow Jones Industrial Average (DJIA) that is more than a month long. Since the last secondary low for DJIA the down trends have lasted roughly a month. If DJIA closes at the current level today it will be in a down trend that is now six weeks old. The transports (DJTA) are now in a down trend that is six months long. One of the tenets of Dow Theory is that bull markets will have long up trends and short down trends. In context of the two and a half year rally out of the 2012 lows neither of these declines are significant, but they do point to a changing character in the market. As a reminder, Dow Theory is still in a long term bullish trend. The current declines haven’t changed that trend. I’ll keep you updated to any significant or interesting things that happen with Dow Theory. Another thing that