Strangely enough, after seeing the fallout from the news of Greece’s failure to come to an agreement with its creditors, I’m left with a sense of relief. The setup for a very good-looking buying opportunity is now developing. In the meantime, we’ll continue to hold our positions in uptrends while cutting positions that break stops following our risk control mandates. This has quickly become one of those high anxiety moments that needs a cool mind.
Greece is going to go through a rough time as it has through several periods in the past – not their first default. Acute economic pain is happening now (in Greece) and will not go away soon. In fact, they will not recover economically for years to come. I don’t know if Greece will remain in the Eurozone or not, but I’m not sure it matters ultimately. We must remember that Greece represents only 2% of Europe’s GDP. To what degree the pain really spreads and infects the rest of the Europe and the global financial markets remains to be seen. I am skeptical that by itself, Greece will ultimately cause more than headline risk to the global financial markets. There is the possibility that Greece is just a catalyst for a deeper global stock market correction that wants (needs) to happen anyway. The end is approaching in this very lengthy saga with pain recognized and managed. To that end, I am relieved.
On A Very Damaging Day For Global Stocks
As I have said many times in the last six months, 2015 will be a Transition Year and potentially a negative year for investment portfolios. I use the phrase Transition Year because the markets and the economy have approached a cyclical moment where both are adjusting to life without the massive support of central bank easy money. Stocks must also justify staying at their high valuations by seeing commensurate growth in earnings. Both of these issues will become front and center to investors starting on July 8th, with the kick off of the 2ndquarter earning’s season, continuing on into September with concerns about the Fed’s first rate hike. On the potential for a negative year in stocks statistically, the odds are simply not in our favor for a 7th consecutive year of gains. Why? Because it has never happened.
Monday’s loss erased all of 2015’s gains in a matter of a few hours. The breakdown in certain market sectors didn’t happen Monday, it began in April when we saw distinct peaks in utilities, bonds and the transportation sector, all of which made new lows last Friday. High yield bonds, which tend to act as canaries for the market, also peaked in April and May. Technically, we have seen divergences and deterioration in market breadth and participation since late April and May as well but until Monday, the market was really hanging tough trading at or very near all time highs. Now, we see all of this evidence coming home starting with Monday's very notable move lower.
On How We’re Playing This
Last week, we began cutting out several of our higher risk positions and did more follow through selling on Monday. Tactical Equity and Blended Asset models now carry 20-25% cash positions with the remainder tentatively holding positions that are still above their stops. Last week, our income models moved decisively to almost 80% cash as the remainder of our corporate bonds, floating rate and municipal bond funds broke stops. Technically, Monday did a lot of damage to the markets (and our strategies) but at the same time, the “event” pushed many indicators into deep oversold territory, close to levels where we often see healthy bounces.
Presently, we are moving from a fully invested allocation to a more defensive position, selling as individual positions break trailing stops or sell signals only. Our Net Exposure, Selection and Position size criteria for portfolio holdings are all dictating our actions. Like the market, we’ll give up some gains on the way with the goal of avoiding the more significant losses that create bigger issues and longer recovery times. What we have seen so far is a lot of technical damage to the markets but the primary trend is still up (marginally). In fact, prices have now moved very swiftly back to the long term uptrending averages which tend to act as support for stocks. Clearly, any buys now would be guesswork with little evidence that a bottom is in, so we’ll wait.
What They Don’t Want You To Know – Part 2
The vast majority of investment portfolios are built on the premise of “Modern Portfolio Theory” (MPT) where we have different asset classes, sectors, styles and size categories that offer us the perceived safety of a diversified portfolio. Most models rely on a set of assumptions called “reversion to the mean”, or the tendency for every security to move from high or low extremes back to an average over time. These are quantifiable risks as they can be measured with standard deviations or pricing models. Thus we can easily build portfolios that almost eliminate the risks of having all eggs in one basket with the right blend of securities. The problem with all of the models surrounding MPT is that they only eliminate what is called systematic risk or quantifiable risks. Now look back at a day like Monday, 6/29/15, when near every sector, asset class and security lost 2-3%. What good did diversification do on a day like that? It did zip in controlling your losses. Bear markets are governed by weeks and multi month periods where non-systematic risk is present created by investor’s need to cut losses in an environment when liquidity is shrinking or non-existent. Non-systematic risk can’t be modeled or priced or diversified away because during these periods all ships fall with the tide. Statistically, again from the good work of Greg Morris, periods of non-systematic risk govern the markets between 60 and 70% of the time.
In other words, Modern Portfolio Theory and all of its various pricing models are only valid and useful 30-40% of the time. So what can we take away from this?
Investors should not take comfort in simple diversification as the only means to control capital losses. This is the battle cry of the passive investing crowd and only those with the very deepest of pockets (like Bogle himself) can really tolerate the realities of a market in the grips of non-systematic risk. Ironically, diversification and thereby MPT only work when markets are rising in a normal uptrend – when you don’t really need it! When non-systematic risk takes hold of market trends, you need a system of stops that pulls capital off to the sidelines. In truth, net exposure to the markets (our primary investment screen) is what really matters the most in both rising and falling markets. Selection (diversification) is relevant but secondary. Let Monday's market action serve as a reminder that non-systematic risk is always there and every investor needs to have some method to deal with it.
That’s it for this messy, headline driven quarter and I’m glad it’s over frankly. There will be no Red Sky Report next week as we will be writing the Quarterly Change of Seasons Report.