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Wanna Play a Game?

Here’s the deal.  You have a one in six chance of winning.  It costs $10 to play and you have the chance to win $1Million in cash.  Pretty good odds right?  If you want play, read on.  (hat tip to recently retired Greg Morris for this)

The Cost of Not Winning

The game is called Russian Roulette.  Still want to play? Hmmmm maybe not.  Despite the favorable odds of winning and the bountiful reward for doing so, we just don’t like the cost of not-winning (death) enough to play that game right?  You know where I’m going with this.  After 12 back to back meetings with clients over the last two days, I heard a common theme emerge.  Everyone had noted the “flatness” of returns over the last 6 months or so.  True many market indices did peak in July of last year when the US dollar developed a very strong uptrend taking down earnings for the last two quarters substantially.  Domestic stocks have simply moved in a pattern that reflects a soft spot in the economy and a zero sum game among dollar related winning and losing sectors.  Take a look at the chart below.  In Red, I show the NYSE Index and in Green, I show UUP, the rising US dollar ETF. 


Notice how the NYSE went flat starting almost exactly at the time when the US Dollar started to rise dramatically.  Also notice that the stock index is trying hard to break out of the flat zone with the recent weakness in the US dollar but has yet to do so meaningfully.  Our own strategies have followed a similar pattern to the US stock market albeit with a slight upward bias and less weekly volatility.   So the flatness and the lack of returns since last July is being noticed and there are two ensuing questions that emerge. 

The first is, is the market getting ready to crash as so many predict?  We have no way of knowing that answer, so I shrug and say, “I don’t know”.   Anything can happen at any time in the investing world.  However, we do our have our indicators that help us assess overall market risk.  At the moment, we don’t have much indicating that this flat period is anything more than a healthy digestion period or an adjustment cycle as investors get ready for a less accommodative Federal Reserve (read rising rates) and the realities of a stronger US dollar.  Frankly, I’m very impressed with how well the market is behaving considering recent economic reports and earnings!  This is an overly simplistic assessment but so far, we don’t see this pattern as anything other than a long pause in a long but aging bull market.

The second question is always about taking on more risk to generate more returns.  These are the emotional strings that pull us toward risk when perhaps the COST OF NOT WINNING that game are now too substantial.  I think the situation in the market calls for a hold strategy from here on out frankly.  In other words, if one feels compelled to make money every week and every month, then it will require a lot of return chasing at this point. The odds of being rewarded for that additional risk taking (buying more stock or stock indices) are still reasonable but I do wonder how much of that return you will ultimately keep?   Back to our game-riddle.  There is likely more return available in the markets.   But as I clearly stated at the annual meeting last October, there are no more free rides.  Returns will be earned in a much higher risk environment from here on out for reasons that I will outline below.  We are comfortable remaining fully invested in our various strategies because we are also quite confident in our system, which will lead us to become more defensive at the appropriate time.  But for those who think they are capable of passively holding their investments through thick and thin, you should understand the real cost of not-winning this game. 

According to the excellent research of Jim Stack with Investech Research, over the past 85 years of market history, every bear market except one (1956) has recaptured or repossessed close to one-half or more of the previous bull market’s gain. Out of 15 identified multi-year bear markets, five of them repossessed more 100% or more of the entire previous bull market gains.  He estimates the potential loss in the broad based S&P 500 index to be something close to -34%.  Of course, that’s just an average so the carnage in certain areas would be far worse.  Again, I am not suggesting a bear market is immanent at this time but simply pointing to the costs of not-winning.  Even if the odds of winning were 1 and 6, the costs of not winning (like Russian Roulette) suggest this is not the time to take on additional risks in your portfolio without a robust downside protection system to guide you. Passively owning a bunch of low cost stock index ETFs is the absence of system despite what the media tells you.


10 Real Risks to the Market

I’m going to keep this brief and in bullet point fashion to get it out without pushing your patience.  They are as follows (again, thanks to Jim Stack for the top 6):

  1. 1. The age of the current bull market – one of the longest and strongest in history – all behind us.  What’s next?  Another super strong bull market?  Not likely before a substantial correction.

2. Margin Debt –now at the same levels we saw in the year 2000 and 2007, both peak years for the last bull markets.

3. Sentiment is too bullish among Advisors - Again at levels seen at significant market peaks.

4. Corporate profit and earnings may have peaked – while still positive the rate of change in earning is now turning negative from a historically high level.  Investors only care about the direction of earnings, not the absolute value.

5. Market momentum may have peaked as far back as March of 2014; many prices may have done so in July of 2014 as well. 

6. Valuations are high – Same level as many other major market peaks.

7. Cyclical sectors like Transports are not confirming recent highs in the Dow.

8. Utilities are also not confirming the move in the Dow – Dow Theory sell signal.

9. Fed is going to raise rates in 2015 – Market typically experiences an 8-10% correction at or before that event.

10.  Market may be losing its leadership – Tech and healthcare have been the leaders.  Keep your eyes on both. 

All in, I would have to say that market action over the course of the next 2-3 weeks will be critical to watch as an strong indication of whether or not we are headed for deep correction this summer or whether we can see another surge higher to Dow 20,000.  We continue to hold and hope for the later but also ready to cut and run if necessary.

Have a great week and know that we are very carefully watching this situation. 


Sam Jones 

President, All Season Financial Advisors