2015 was a year of intermediate term whipsaws. 2016 saw longer term indicators whipsawing. The longest term indicator I follow is Dow Theory. It looks for trends that last from one to three years (or longer). As a result, Dow Theory gives a lot of leeway to counter trend moves. It’s common to have a 10% or 15% correction during a long term bull market that doesn’t change Dow Theory’s long term trend. You can see some examples during the long term uptrend from mid 2009 to early 2016 in the chart below.
Zooming in to the last few years, you can see what appeared to be a long term trend change according to Dow Theory. In August of 2015, both the industrials (DJIA) and the transports (DJTA) had large enough corrections to mark Dow Theory secondary lows. In December of that year, DJTA broke below its secondary low point and created a bearish non-confirmation in the indexes. In February 2016, DJTA broke its secondary low point. This created a Dow Theory change of trend from bullish to bearish. Unfortunately, the signal ended up being a whipsaw. Instead of a year or more of downward movement, DJIA rallied immediately and in just over two months created a bullish non-confirmation of the down trend. DJTA followed in early October, signaling a long term trend change from bearish to bullish. A massive whipsaw, which is not common in Dow Theory.
Another long term indicator that whipsawed during 2016 is the combination of monthly Momentum and MACD. This is another indicator that is fairly reliable for long term trend changes. It does tend to whipsaw during risk events (such as the 1987 crash and the Iraq invasion of Kuwait in 1990). As a result, it is a better indicator for tops that build over time, such as the rounded top in 2015… or so you’d think. By early 2016 it appeared that both Momentum and MACD on a monthly time frame were signaling a long term trend change. But it wasn’t to be. Instead, it turned out to be another long term indicator whipsawing.
The next indicator that I follow that whipsawed the most is my market risk indicator. It looks for risk events in the immediate future. If you look at the chart below you’ll see market risk warnings in red. This chart also has yellow lines depicting deterioration of my core indicators and green lines indicating strengthening core indicators. During late December 2015 and early January 2016 my core indicator weakened to the point that the portfolio allocations were 100% cash or fully hedged with a market short. A week later, my market risk indicator signaled. It appeared as if we were seeing a classic intermediate term trend change. Which was followed by Dow Theory and MACD long term trend change signals. Oops! Another whipsaw. Although the market did traded lower after the market risk warning, it wasn’t the substantial decline one would expect with everything signaling a bear market.
Then later in the year there were two more risk events that cause market risk warnings. They were Brexit and the US elections. Both of those warnings were cleared by the next week, but not without damage to the portfolio performances.
The core indicators performed as I would expect during a year that had so much choppy sideways movement (before bursts higher).
Which brings us to portfolio performance. As you should expect in a year with three market risk whipsaws, the portfolios that rely on aggressive hedging during risk warnings fared the worst. The Long / Short portfolio suffered a 6.8% loss. Most of this loss came in early January before the portfolio was hedged. Then throughout the year, the high beta stocks just didn’t perform in cycle with market rallies and the core indicators, leaving the portfolio about where it was after the first week of the year had done its damage.
Next comes the Volatility Hedged portfolio that only changes allocation when market risk is warning or is cleared. This portfolio suffered a 5.6% loss. Like the Long / Short portfolio most of it occurred in the first few weeks of the year. The Volatility Hedged portfolio recovered during the year, but then gave back gains just before the US elections.
The Long / Cash portfolios fared better due to their lack of aggressive hedging when risk is high. The core Long / Cash portfolio doesn’t change allocation on market risk warnings so it did the best, with a gain of 3.3%. The Long / Cash portfolio that goes 100% to cash on a risk warning lost 1.6%. Not a great year, but understandable given several periods of sideways movement then bursts higher. Remember the core health indicators are looking for intermediate term trends that are sustained. As a result, they will perform better with larger rallies and declines.
In a year of whipsaws and choppy sideways movement the portfolios gave disappointing returns, even if they performed as expected. Remember, they aren’t designed to track every movement in the market. Instead, they are designed to give comparable returns to the market over the long term without suffering catastrophic or unrecoverable losses. They tend to under perform during bull markets (especially during choppy sideways movements) and over perform during bear markets.