I must admit that the rally off the lows in late December has been impressive. We expected some sort of a rebound rally from the extreme oversold condition set up on 12/24 but this was a whopper. Now that the market has moved all the way back up to the failure point and our predefined resistance level, we must consider several outcomes. Inside, we’ll review the current state of our Net Exposure model and look at the market from half full and half empty perspectives.
Bear Market Rallies
I am recalling the true words of the late Richard Russell who was a long-time market guru, and famed author of the Dow Theory Letters to which I subscribed for over 15 years before his passing in November of 2015. Richard was one of the greats. He was a no b.s., call it like it is, been-here-before, kind of writer that I resonated with, obviously. He would often remind his readers that bear markets have one purpose.They exist to suck in wealth convincingly and then destroy it. He said, “everyone loses in a bear market, but he who loses the least wins”. That’s good context for this subject. Bear market rallies, defined as any rally that occurs below a declining 200 day moving average “trend”, can be very strong, very convincing but are usually opportunities to sell or short the market.Take a look at this quick mock up of the chart of the S&P 500. The Blue line (hard to see) is the declining 200 day moving average. And the bear market rally since the beginning of 2019 has been magnificent, but unfortunately doesn’t change the trend of the market which is still DOWN.
In fact, bear market rallies are some of the strongest if one looks at gains / week or month. The current rally is indeed one of the strongest we have seen in nearly a decade. But we must also remember that this is happening following one of the worst quarters (q4 2018) in a century. So is the beginning of a new bull market (half full) where we should expect higher highs or is this simply a bear market rally within a longer term downtrend (half empty)?
The Nature of the Pullback Will Tell All
We’re expecting a market pullback to begin now.What we don’t know and can’t even establish yet is how deep or long this pullback might last. It could be very quick, like just a few days or weeks. It could also be shallow in terms of price damage which would look like a pause on the way to higher prices. Or, it could take us all the way back to the lows in December or beyond. We just don’t know. What we do know is that this is an obvious inflection point and a place where we should expect a retracement of some sort to begin. In a perfect world, prices would actually fall pretty far back toward the last lows and settle at or above 2400 on the S&P 500. Then, if buyers emerged in force again, we would have a much better-looking durable low from which to establish some longer-term bullish investments. But for now, all we have is a single spike low and roaring retracement rally. We really need a multi-month, complex base to indicate that sellers are done selling.As risk managers we consider probabilities and outcomes, risk to our portfolios in terms of losses and the state of our Net Exposure model to help guide us at inflection points like this.Let’s take a look.
Net Exposure Model Still Negative (-2 on a scale of -20 to +20)
I would have thought our model would have gone positive after three weeks of very healthy price gains… but it didn’t. Price trend is a very large and important variable in our model and the trend of the market is still clearly down. Until prices are trading above the 200 day moving average and the slope of that average is positive, our trend weighting will effectively anchor our Net Exposure model below zero. Furthermore, we now have an overbought situation coming from some of our shorter term momentum indicators and sentiment figures.Bullishness, as a sentiment indicator, is high again which is bad for markets looking forward and price oscillators are as stretched to the upside as we’ve ever seen them. These too weigh on our model as negatives. When our Net Exposure model is negative, we have several mandates. We can trade the market as we’ve been doing with basic index exposure buying low and selling high. We can also sit in cash, bonds or gold, but we cannot assume that any stock positions will be held long term. A negative model reading dictates that when stops are hit, positions are sold to cash and we wait for a better environment to upgrade to different securities. That is the situation we’re in now. Today, we sold one of our largest stock market index trading positions (IVE) which we picked up near the lows and put the proceeds in the bank. Our Tactical Equity models also initiated a small hedge (short position) against the S&P 500 to help mitigate any losses that might occur on a deeper pullback.Again, we don’t know the nature of the pullback but this is the inflection point and our first obvious opportunity to capture gains, recoup some losses from 2018 and manage market risk appropriately.
New Opportunities Developing
To finish on a positive note, this rally has daylighted opportunities in many deeply oversold and deep value individual stocks and industry groups. We’ll be talking more about these in our upcoming Solution Series “Investment Forecast for 2019” on the 30th, but we’re excited to see new life in areas of the market that were left for dead. Emerging markets are waking up and still showing solid leadership as Sean Power’s mentioned in his quarterly Change of Seasons report. We are also seeing opportunities in some of the late cycle leaders like materials and industrials which were smashed in late 2018 and present attractive values again. Homebuilders are waking up along with select commodity groups. Finally, we see some hybrid options in the credit markets like emerging market bonds, preferred securities and investment grade corporate bonds showing up as relative strength leaders again. There are things to own that we really like and hope they will continue trading higher regardless of what “the market” does. So far, so good.
That’s it for now, just a quick status report given current conditions.
Stay tuned and please RSVP to our Solutions Series if you’d like to attend. Space is limited and becoming more limited by the day.
Cheers,
Sam Jones
