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What Is The Recent Market Decline Telling Us About the Future?

     Most investors tend to pay way too much attention to price changes in the major stock benchmark averages.  Often times, I get a funny look when people ask me where the Dow closed today and I can’t tell them.

But I thought you managed money?

I do, but what does the level of the Dow Index have to do with anything?

     We like to look into the character of every market advance and decline for clues about what we might expect looking forward.  There’s a lot more relevant information under the hood of index price action.  Let’s take a look.

Investors Own What They Don’t Understand

     Bitcoin is an easy target and I won’t beat that dead horse.  Bitcoin was trading as high as $19,800 and recently moved below $6000 in just a few short weeks.  I will take this moment to say – I told you so.  Maybe it will go up, maybe it will go to zero but the fact remains that hundreds of Billions of dollars in wealth is being erased at an alarming rate.  Bitcoin owners still don’t know what it is but most now understand that is causes great wealth destruction. 

     The same goes for investment products like leveraged ETFs tied to derivative markets.  XIV is a symbol that is worth looking at on www.stockcharts.com

     This is an ETF that shorts market volatility.  It is now gone and in liquidation following a small print line in the prospectus that allows the fund to simply close following a loss of 50% or more without any obligation to investors.  Investors who have no business owning these products of mass destruction just lost everything, well 95% as of this am in about 26 hours.  What can you tell me about XIV Mr. Investor?  Silence. 

     The market is not kind to investors who chase “stuff” just because it appears to be going up fast. 

What does this tell us about the future?

     Investors will be far more gun shy about gambling and speculating from here on out.  In fact, this type of event tends to push investors to the other end of the spectrum where they will find the likes of Johnson and Johnson or a dividend payer suddenly VERY attractive.  Watch the Value and Defensive side of the market for relative strength in the weeks and months to come.

Risk Versus Volatility

As we define in our “Explicit Investing Creed” on our website, www.allseasonfunds.com ,

RISK (DEFN.)

  • The probability of unrecoverable or semi-permanent loss of capital, not to be confused with variable degrees of periodic volatility.

     Let’s talk about that in the context of the recent decline in global stock prices.  Today we have an obvious spike in volatility, meaning big price moves down in a short period of time.  This one looks like the type we saw in 2011 and again in mid-2015, which I would describe as mini-crashes seemingly out of thin air from recent all-time highs.  These are the tough ones because everyone tends to have a lot of money on the table after years of steady and predictable price advances. So volatility is now with us as we feel the effects of the first “drawdown” in almost a complete year.  Drawdowns are market words for declines in your portfolio balances associated with market losses.

     While I hear a lot of whistling past the graveyard in the current commentary, I also hear a lot of fear in the system.  I hear investors assuming that “RISK’ has entered the picture and a bear market is upon us.  I hear comments like, “This is 2008 all over again” or “Here it comes, I knew it” or “This is going to be worse than anything we’ve ever seen”.  Clearly, investors are assuming that they will experience an unrecoverable or semi-permanent loss of capital from here.  But so far, we don’t have enough actual evidence to suggest that we are seeing anything other than volatility.  Am I whistling too?  Not yet. 

     With that said, Volatility always shows up before Risk so we have to respect the recent break of the trend in market prices. I can say with high confidence that the days of record low volatility in the markets are over perhaps for a long time (years?).   Volatility can and should be managed with some portfolio changes, while “Risk” is to be strictly avoided with a maximum defensive posture.  As regular readers know we went into February with almost 20% cash.  Now that number is 30-40% depending on the strategy.  That is not maximum cash or max defensive positioning, but rather an appropriate reaction to some obvious new volatility in play.  The weight of evidence is in sync with our allocations.    

Computers Are Making Decisions

     This is not a statement about computers taking over but rather an honest understanding that much of what we see in price action today is the result of quant and algorithmic trading programs hitting the sell button simultaneously.  Don’t blame the computer, it’s just doing what you told it to do right?  But the effect is that prices no longer roll up and roll down, they spike up and spike down as trading programs move mountains of investor dollars all at once.  This is a bad thing because it creates a great deal of chaos when things are already a bit uncomfortable for us simple humans.  In fact, the program driven selling probably has the effect of driving other more subjective traders to sell as well in a negative feedback loop. 

     Looking forward, we should expect more of the same.  Program trading is not going away for as long as it remains unregulated and as long as it holds a timing edge over the guy who is still working for a living and doesn’t have time to day trade on 5-minute charts.  So if program trading is with us, we need to really manage our money differently.  We can’t assume that our all stock portfolio will offer us a smooth ride forever if the program trading systems are going to “Bitcoin” (let’s make it a verb) on the other side.  Simply put, investors have got to become more mature about their portfolios.  Specifically, we’ve got to get back to portfolio construction and asset allocation owning a group of non-correlated holdings through all types of markets.  Today, everyone is still on one side of the boat – ALL STOCK.  Our clients at All Season Financial understand that we’re pretty strict about maintaining their allocations to our “Tactical Equity”, “Blended Asset” and “High Income” strategies.  In every review we show our clients what their Prescribed allocation is compared to their mix as well as their deviation from that prescription.  Our clients understand that the magic of consistent returns over time is about maintaining the mix of non-correlated strategies while making adjustments to exposure over time.  We don’t assume that we’ll beat the program trading systems to the exit door on a daily basis, because we don’t have to.

Stocks and Bonds Carving Out a Short Term Bottom Together

     Many are still looking for that elusive reasoning behind the stock market’s decline.  They are erroneously blaming the increase in interest rates at present.  Interest rates are not high enough to be a problem for stocks from any perspective so that’s not right.  But the interesting fact to note here is that bonds are moving in sync with stocks.  They are moving together in price for the first time since late 1999.  The good news is that we might find an attractive BUY in bonds for the first time in a while just as stocks are also carving out the first good looking BUY in a long time.   From a timing perspective, today and the massive reversal to the upside on a Friday close should set up the first technical low.  Bonds are also looking like they want to bottom.  We are not likely to buy either asset class with our heavy cash position until we see a rebound of some reasonable magnitude followed by another retest of these very same low levels, most likely in mid-March.  It’s a good rule of investing to never buy the first low.  Always wait for some sort of retest to confirm that the floor is solid.

If you’re looking for markers, it would be likely that the S&P 500 would rebound back up to 2730 from here, almost 6% higher, and then we’d see another round of selling back to the current levels.  Current levels mean the lows established by the overnight futures price action on February 5th, which was 2529 on the S&P 500.  Today, at the very worst moment of the day the S&P 500 reached down to…. Wait for it… 2529!

Bang, that’s probably going to be a short-term bottom.  Cross our fingers.

That’s it for today – have a peaceful weekend and don’t think about the markets.

Cheers,

Sam Jones