The US stock market started into a new correction pattern on the 3rd of July and that condition remains the same today despite some marginal evidence to the contrary. This may prove to be just another brief decline before blasting out to new highs or the beginning of something more significant. Either way, those interested in preservation of capital probably need to consider making some changes toward defense.
New High for the Dow, New Lows for Small Caps?
This subject has been kicked around the media for several months now and I’ve heard all the justifications for why small caps are under-performing. Most notably, the primary excuse is that they did so darn well in 2013, that we should all expect then to experience some profit taking. Maybe. But in my years of experience, small caps under perform for one reason and that is that the market as a whole has a growing sense of concern for holdings that carry larger risks of loss or concerns over liquidity. Small caps are to large caps as high yield bonds are to treasury bonds. When perceived risks increase, larger investors cut out of the riskier assets first. As the Dow made an all time new high last week (with a whopping 3% gain YTD), small caps quietly lost money again, made a new low and are now negative YTD. Excuses aside, this is not a good thing.
High Yield Sell Signal (early)
Speaking of canaries in the coal mine, as of today, we did get our first very early sell signal for high yield corporate bonds. Again, this is early and based only on the most volatile of our high yield corporate bond holdings but it does appear to be a solid sell signal. The last time we made a trade for our High Yield bond allocations was solid BUY on the 16th of September last year. Today we cut our more volatile high yield bond holdings down by 50% and sent the proceeds to cash. Several of our other high yield positions in All Season, Freeway High Income and Retirement Income are also getting close to sells but we’ll wait for the actual signal – as always. Again, in my experience, when high yield corporate bonds sell off ahead of the broad stock market indices, the market usually follows lower in the next couple weeks. Another warning shot for those who are paying attention.
Jump in Volatility
Last Thursday (7/17/2014) consistent with both items above, one of our short term market trend indicators based on the rate of change in the VIX index also tripped to a sell signal as the VIX jumped almost 32% in a single day. The VIX is widely misunderstood and we do not trade on its absolute value but rather watch the change in this indicator off extremes as a sign of quickly shifting sentiment among options traders. This is a useful indicator typically only at market tops and market bottoms but relatively useless in between. The VIX is a market measure of volatility but more importantly, a way for us to measure the appetite for risk insurance. A rising level means options traders want to protect themselves and visa-versa. For weeks, the VIX has been trading at a historically low level (less than 11), like we have seen in the final months of most extended bull markets. Low volatility is a sign that investors are fat and happy, worried about very little in terms of market risk. In fact, these are the very times when investors begin to think that investing is rather easy. The Do-It-Yourself investor comes out of the closet and quits his tiresome day job. Cash is deployed in mass as it seems the coast is finally clear. They forget that markets can be brutal because it’s been so long since anyone felt any real pain. They often look only at the tiny expense of things and become complacent about the real costs of losing one’s capital. Last week, without much fanfare, the VIX shot vertically higher off a multi-year low level as I hear and witness all of the above. Someone just poked the bear. He now has one eye open and he’s a bit hungry. Now if we can all just sing a quiet lullaby, perhaps he’ll hit the snooze button. Or, perhaps we should tighten up all sell stops on current positions (wink).
Strongest Part of the Presidential Cycle Directly Ahead
Finishing on a positive note, we remain very open to the possibility that the current correction could be just another great buying opportunity ahead of one of the strongest periods in the presidential cycle. The historical averages of all presidential cycles shows general weakness for stocks into the end of the current quarter followed by 4 consecutive quarters of rather incredible gains (5-7% each quarter). A big part of me intends to be involved in that kind of uptrend if it happens but I also want to survive the current quarter if it turns out to be a bit bloody ahead of that surge. For the record, 2013 was not supposed to be the blow out year that it was as dictated by this same cycle. The S&P 500 gained nearly 30%. The cycle says 2013 should have been a low single digit year. Are all the “presidential cycle” gains behind us or still in front of us?
Do You Have a Risk Management System in Place?
Given the current weakness in the market, combined with a growing list of technical warning flags coming off a very long period of low volatility, it would seem natural for us to see some sort of significant “unexpected” decline in stock prices in the weeks ahead. However, this same decline, like many in the past, could be one of the last great buys ahead of another very profitable market cycle. How much of a loss can you tolerate to stick it out? Should you wait to see what happens or act now? What will tell you when to get back in? Two weeks ago, I spoke of our risk management systems (“Risk Controls”). If you don’t have a system that answers these questions, then you should work to develop one quickly or pay someone who does have a system. Not having a risk management system in place for your investments after a 190% gain in the stock market over 5 years is not an option.
Keep both hands on the wheel and have a safe week.