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Cutting Exposure

Cutting Exposure


     In our home, we regularly have those conversations with our teenagers about good judgment. We frame it like this. “Ya know, the risk to reward tradeoff for that just isn’t very attractive. You have a lot more to lose than gain”. Somehow, our teens get that. We all do. As of 1/27, several of our indicators governing our Net Exposure system reached a point where … The risk to reward tradeoff is no longer attractive. As a result, sticking with our system, we are raising cash. You may notice several trades today and will see a few more in the coming days.


But The Markets Are At All Time Highs


     As you know, on November 4th of 2016, we issued the Calling All Cars directive to all clients suggesting that the markets had reached an oversold and attractive buying opportunity. Oddly enough, this happened just days before our presidential election with an unknown outcome and impact on stocks. Since then, the markets exploded higher by 8-12% through yesterday. Our own Tactical Equity and Blended Asset strategies tacked on a quick 6-9% and our income models added +2-3% even while bonds lost nearly -9%. This has been a great run for stocks but one that has largely pulled forward a lot of 2017’s calendar year returns based on hope and speculation. The uptrend in stocks is still healthy and good to be clear but it has also approached an extreme from our measures of overbought and overvalued. Take a look at this quick screen shot of the VIX (Volatility Index). This index measures… you guessed it…. Implied volatility taken from options pricing. When the number is low, it suggests that stock market prices are moving higher without much concern (options are cheap). When it rises, suddenly and dramatically, it reflects panic during steep sell-offs (options get expensive). In our shop, we have a little bell that rings when the VIX hits anything below 11. On 1/27, the VIX hit 10.58. Any reading below 11, in recent history has been one of the harbingers of corrections to come. After all, when everyone is overly confident and prices are bid way up, we tend to see corrections occur. The last time we saw the VIX under 11 was July 3rd of 2014. 72 days later the S&P 500 was down -6.19%. As a matter of fact, the S&P 500 continued to struggle after that date for another 405 days until February of 2016 when the final lows were made. 405 days! 

     So today, prices are indeed tickling the all-time highs and we have yet to see a correction, but the VIX, and several other indicators like it, are telling us to expect HIGHER VOLATILITY in the days and weeks ahead. Today, we sold some of our index fund exposure and raised cash across all strategies (by 15-25%). Sell high, buy low right?


Selection Screen Changing


     As we wrapped up 2016, the market was screaming for Trump stocks. These are the energy groups, stocks that benefit from infrastructure spending, economic growth, and domestic industrials. It was an easy and predictable trade as the shock of Trump in office became a speculative trade overnight. Now, in the new year, post-inauguration, some questions and doubt have entered the scene driving leadership back to other sectors and asset classes. One notable change has been the direction of the US dollar, which until the beginning of 2017, was in a strong uptrend. Now, the uptrend is stalling or worse. A rising US dollar indicates a strong and growing economy. Maybe the market is beginning to understand that Trump’s policies may not make America as Great as promised, at least not by the end of the first quarter (wink). The trend of the US dollar has a profound impact on sector and asset class performance.

     Also changing from last year is a surge in large cap growth via the likes of the Nasdaq 100 index (QQQ). Small caps were the big winner in 2016, now they can’t seem to stop underperforming large caps. Likewise, while industrials, materials, and energy have been topping the charts for gains since the election, they are beginning to show signs of weakness, especially as earnings come home in full color. These groups should be doing well if Trump is going to get his way and they likely will to some degree. But for now, the hope factor may have gotten ahead of the fact factor. 

     Finally, with all the chatter about trade barriers, walls, trashing trade agreements and generally pissing off our global manufacturing partners, it seems that most international indexes are now beginning to show some notable relative strength to the US market. Some of this has to do with the fall in the US dollar of course. But, the 2017 YTD strength in internationals is pretty dramatic. Take a look at how leadership across the globe has changed YTD, Since the Fed Rate hike in December and Since Elections.


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Not Leaving The Market


     As of now, we have only an overbought market but not much more to worry about than that. The economy seems to be on fairly strong footing as it has been since last summer before elections. The Fed is playing nice with predictable commentary and actions and earnings are coming in right in line with expectations, even a bit stronger. The markets will follow earnings growth and thus we are not exiting the market altogether as much as cutting some exposure as the market comes back to earth a bit in terms of expectations, prices and the facts (the real ones). We are simply moving to the first tier of our cash allocations considering recent extremes in several indicators. Net exposure to the markets is the largest determinant of performance in any one investment portfolio and we make these timely adjustments for our clients based on our proprietary system as part of our core value proposition. If things get really ugly, we will become even more defensive but for now, we’re just putting one foot out the door.

     From a timing perspective, March and April are notably the best months of the year for returns and we want to keep our hand in the game giving it the benefit of the doubt. However, worries about the Fed and a potential rate hike as soon as March will begin creeping into the narrative as well as additional information regarding disruptive policies from the Whitehouse. We are expecting higher volatility either way.

     I look forward to seeing many of you at the upcoming Investment Forecast 2017 Solution Series at our office on February 15th which is now overbooked and completely full. We’ll talk a lot about market trends under the new president, the state of this aging bull market and where things are likely to go from here. The presentation will be sent out to current clients after the meeting.


Stay tuned


Sam Jones