Just a quick note this week. The damage done to our core indicators hasn’t been repaired by the rally back near the old highs in the S&P 500 Index. Part of the reason our indicators are having trouble clearing is a result of the steep V pattern being painted so fast that price is outrunning everything else (causing our indicators to lag). Unfortunately, that isn’t the only problem. A larger problem is that our measures of the economy and market quality are still falling. This poses a longer term problem for the market as a whole. So here we are, back at all time highs and hedged. Long time readers know this isn’t a cause for concern…because hedging isn’t about being right or wrong. It’s about acknowledging I can’t see the future so I simply hedge out risk if our indicators are warning or unclear. Our current allocations for the long/cash portfolios are 100% cash. Our hedged portfolio is 50% long stocks we believe will out perform the market in
Our market risk indicator warned on 10/10/14 and since that time the market has dropped and recovered in an extremely sharp V formation. The quick move is causing the indicator to whipsaw on a daily basis. It has been moving back and forth between warning and clearing the warning. If the market doesn’t fall sharply between now and Friday I expect the warning to be cleared which will cause a whipsaw hedge signal as discussed in this post. With that said, the picture is still cloudy so we’ll have to wait until week’s end for clarification. As always, I’ll post before the last hour of trading with an official call (and any portfolio allocation changes). One point on the issue of whipsaws. Please be aware that this indicator is specifically designed to warn of the heightened possibility of quick drops in the market. It has a good record of warning before big declines, but also has a lot of whipsaws. As a result, we use it mainly for a signal to
Our Market Risk Indicator signaled last Friday in the last hour of trading which caused us to add an aggressive hedge to the hedged portfolio. I have to say that I was surprised to see an acceleration of the selling without some consolidation near the 200 day moving average for the S&P 500 Index (SPX) first. The reason for my surprise is that the market had already fallen sharply before the signal came and that condition often causes whip saws in the indicator. The market has since recovered much of the decline from earlier in the week. So what do we do next? If the market continues to rally I suspect that our risk indicator will clear its warning within a week or so (similar to the whip saws in March and June of 2011 on the chart below – Note: red lines are risk signals, blue lines are cleared warnings). If this happens then we’ll change our hedge back to a simple short of the S&P 500 index (using
The volatility in the market over the past week was accompanied by a deterioration in all of our core market health indicators. Every category is now negative. As a result, our long/cash portfolio allocations are now 100% cash. Our hedged portfolio allocation is 50% long stocks we believe will out perform the market in an uptrend and 50% short the S&P 500 Index (ticker symbol SH). Please note that this isn’t a prediction of a market decline. Instead it is simply acknowledgement that enough things are wrong with our underlying indicators that I feel it prudent to step aside until the indicators give clear positive signs. UPDATE 3:32 PM Eastern – OUR MARKET RISK INDICATOR SIGNALED AFTER THIS INITIAL POST. AS A RESULT, OUR HEDGED PORTFOLIO WILL USE AN AGGRESSIVE HEDGE. Our Market Risk Indicator is very close to a warning, but it hasn’t yet (2 PM Eastern). It will take a steep sell off in today’s remaining trading session to create a signal. If it signals before the close
Our core measures of risk are very close to going negative. If they make it below zero by Friday we’ll be raising more cash and/or adding a larger hedge. Our measures of market quality and strength are also falling, but they’ve got a bit more room before going negative. With that said, the market is due for a bounce so conditions could change quickly. I’ll do a post on Friday well before the close with any changes to our portfolio allocations. This decline is different in nature than the previous two this year in that it appears to be more about portfolio positioning for the longer term than fear (of any kind). The most sensitive components of our Market Risk Indicator aren’t being severely impacted while the slow moving components have rounded out tops and moved below zero. Our core measures of risk (that are completely independent of our Market Risk Indicator) have mostly been diverging with price since the end of last year and are now close to going
Our measures of trend have been bouncing back and forth across the zero line this week and are currently negative. If they are still negative on Friday we’ll be raising more cash and/or adding a larger hedge before the week ends. Here are some of the things I’m watching at the moment. The actively managed short ETF HDGE is currently rising even though a simple short of the S&P 500 Index (SH) is trending lower. This indicates that shorting selected stocks is starting to work. This often happens before the general market falls. In addition, mid term volatility (VXZ) is rising as well. This indicates that investors are getting nervous going into the end of the year. Small cap stocks (IWM) broke below the triangle I’ve been watching with an associated break in momentum from traders on Twitter. The negative gap in breadth between small and large cap stocks continues to grow. While everyone is watching small cap stocks I’m seeing deterioration in large caps under the cover of new
Social media indicators are showing mostly positive signs with some indecision and chasing by traders on Twitter. You can see the full commentary here. In addition, here are some charts of individual stocks with social media indicators for those of you who are interested.
Over the past week we saw a bit of divergence between our core market health indicators. Our measures of quality and risk got better, while our measures of trend and the economy weakened. None of them moved enough to change our core portfolio allocations. Our core measure of risk is still diverging with the last several peaks in the market. Since the extremely overbought condition on this indicator in late 2013 it has mostly painted lower highs as the market moves higher. This indicates that investors are getting less confident with each rally. As I’ve noted before, it takes time to build a top so this indicator provides information and something to watch carefully, but nothing to act on…yet. The most important thing to watch for a sign of a long term top continues to be breadth. So far we’re seeing small chinks in the armor, but nothing serious. The NYSE Advance / Decline Line (NYAD) is an example. It isn’t confirming the new highs in the S&P 500 Index
On Tuesday we mentioned that our measures of trend were negative. That condition has resolved itself so it looks like we won’t be making any portfolio changes tomorrow. This is a good example of avoiding a whip saw by waiting for Friday’s data to make decisions. Our portfolios are designed to be long term in nature and have infrequent allocation changes. Since we use weekly data for all of the signals they tend to track the intermediate term trends. The sensitivity in our measures of trend show how long in the tooth the current long term trend is. Even with new highs our trend measures are barely positive so it won’t take much weakness to raise more cash. I’ll do an update of all of our core market health measures tomorrow.
It’s still early in the week, but I wanted to give you a heads up that our measures of trend are currently negative. We require a weekly close below zero before changing any portfolio allocations so this is simply early warning that we might be raising some cash and adding a larger hedge come Friday…but I’ll wait till Friday to make any changes in order to avoid whip saws. Our market risk indicator has two of its four components signalling, but the two positive components are a long way from a warning. What is interesting about their current condition is that the least sensitive components are warning while the most sensitive are a long way from a signal. This means there is some instability in the underlying market and that we’d quickly get a market risk signal if prices drop substantially. Our core measure of risk fell out of over bought readings in early July, moved back up to kiss overbought in August, and is now falling again. This is