Our Market Risk Indicator cleared its warning this week. However, our core measures of market health are still mired in negative territory. As a result, we’ll be softening the hedge in the hedged portfolio and staying 100% in cash in the long/cash portfolios. To soften the hedge we’re removing put options and/or volatility products. For the model portfolio we’re selling ETFs or ETNs like VXZ, VIXM, or XVZ and replacing it with at short of the S&P 500 Index (you can use the symbol SH). The end result is a portfolio that is roughly 50% long stocks we believe will outperform in an uptrend (high beta stocks are likely candidates for the hedged portfolio) and 50% short the S&P 500 Index. Below is a chart with the changes in our portfolio allocations over the past year. Green lines represent adding exposure, yellow lines are reducing exposure (and adding SH as a hedge), red lines are market risk signals where the hedged portfolio uses instruments that benefit from increasing volatility as
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
Today didn’t do much damage to our core indicators, however, two of the four components of our Market Risk Indicator are warning. A third component is very close to warning and it won’t take much to trigger it. The fourth component is further away and will take a sharp down day like today to make it warn. I just wanted to give you warning that there may be changes to the core portfolios tomorrow (Friday). I’ll update the site and post to Twitter and StockTwits by 3 PM Eastern what our allocations will be going into the close. IF the risk indicator signals the hedged portfolio will go 50% long and use the other 50% to hedge with a mid term or dynamic volatility instrument like (VXZ, XVZ, or VIXM). If you don’t like volatility ETFs then a managed short fund like HDGE is an alternative. For those of you who use put options the strategy would be to stay 100% long, but cover your complete portfolio with intermediate term
The Active Bear ETF (HDGE) is rising, a short of the S&P 500 Index is falling (SPX), and mid term volatility (VXZ) is falling. It tells a simple story. Shorts are working, but not affecting the market, nor causing any fear.
Although I don’t see very many near term concerns in the market, we are seeing some cautiousness by longer term investors. One of the things I like to watch is a comparison between a S&P 500 short (SH), an actively managed bear fund (HDGE), and mid term volatility (VXZ). As the market started to decline at the first of May we saw a slight rise in HDGE which signaled that people were starting to short the market, but were being cautious in pressing them. At the same time VXZ started to rise much more rapidly, which indicated that investors who hedge their portfolios with futures or options further out on the curve were adding protection. VXZ rising shows investors placing bets that the market will become volatile sometime over the next four to seven months. The taper talk by Bernanke caused another surge higher in VXZ as people started targeting September to December as the beginning of the end of QE. Once other Fed officials started making dovish comments much
Every weekend I review the charts of the 50 most active stocks on Twitter then place them into categories. This past weekend I noticed that the number of stocks in a confirmed downtrend is growing. In addition, the number of stocks in a confirmed up trend is growing too. The number of stocks that are unclear, showing a divergence, or indicating that a counter trend move is falling. This is somewhat disconcerting for the longer term because it suggests that market participants are piling on to the strong stocks and ignoring the weak stocks. This type of divergence is often one of the first signs of a thinning market. The value players have stopped trying to pick up stocks in down trends while the momentum players are buying anything in an up trend. Our concern is that we may be in the early stages of a blow off top. We want to see this situation resolve with more interest in the weak stocks and also some divergences in sentiment for
We’ve shown this chart a couple of times over the past several weeks, but it continues to give warning as the market rallies higher. A short ETF for the S&P 500 Index (SH) is making new lows today as the S&P 500 Index (SPX) is breaking above its recent range. However, a managed short fund (HDGE) is not confirming the move lower in SH. As we’ve stated before, this condition warns of a larger and more sustained correction than many traders currently expect. Now we’re seeing volatility diverging from SH as well. In the bottom panel of the chart below we show mid-term volatility (VXZ) as an example. Since we’re intermediate term investors we prefer to watch mid-term volatility rather than daily volatility (VIX). VIX moves around too rapidly for us to get much good information about future market potential. By looking at volatility further out on the term structure we get a better feel for a longer term trend. What we look for is a spike in VXZ after
If you read our weekly market overview you know that we had a hard time finding any good news in the internal indicators last week. When so many technical indicators are negative we think it’s good to look for anything positive to see if it has meaning for the market. If you look at the chart below you’ll see that just before large market declines HDGE often trades higher while SH trades sideways. This condition happened before both the 2011 and 2012 declines. Today we’re seeing a contrary divergence where SH is trading higher and HDGE is trading lower. This tells us that the weakest stocks are not being sold en masse. Instead, enough of them have been bought over the past month to cause HDGE to trade lower. At the same time large cap stocks as represented by SH are being sold more aggressively. This is not a condition that generally precedes a sell off. When an unusual condition occurs, we as investors need to take note and try
Our Market Risk Indicator closed the week in negative territory. This signal caused us to aggressively hedge our portfolio. We’re effectively 50% Long and 50% short, but our shorts consist of instruments that will benefit from increased volatility in the market. Some examples are puts against our long positions or mid term volatility like VIXM or VXZ. A lesser alternative would be an actively managed bear fund similar to HDGE. The long portion of our portfolio continues to be stocks that we believe will outperform the general market over the long run. This move in the portfolio is not a prediction of lower prices in the market. Rather, it reflects enough increased risk that we want to insure our portfolio. As we’ve noted before, our Market Risk Indicator has many false signals that are usually short in duration. If this signal is false we expect to take a small loss which we consider paying for insurance. If the signal proves to be correct we expect to make money as volatility
On 7/13/2012 our Long / Short hedging strategy moved from aggressively hedged (using put options, or an actively managed short fund like HDGE, or midterm volatility like VIXM or VXZ) to a full hedge using a short of the S&P 500 index. We’re still long 50% of the portfolio with stocks that we believe will out perform in an up trending market and short 50% using the S&P 500 index. When we’re in this position our expectation is that we’ll make money if the market moves higher (our long stocks should out perform). We expect to lose a little money if the market moves sideways or down…but that’s the price of insurance. The current hedge ratio is 1. On the chart below the green lines get wider as we add exposure. The yellow lines get wider as we remove exposure by adding hedges. The red line indicates an aggressive hedge.