The major equity indices across the globe have fallen dramatically since January 19th. The vast majority of the broad bullish percents, “BP”, indicators I follow are now in columns of O’s and risk levels are high. When the columns are in O’s it tells us more stocks are likely to participate on pullbacks and when the columns are in X’s it tells us more stocks are likely to participate on rallies. I’m now in a defensive mode taking steps to protect wealth, however, from a technical viewpoint, it is not clear yet, if this pullback will be a short term correction or a more meaningful retreat for equities.
On the positive side, relative strength analysis, “RS”, continues to favor equities over cash. In addition, looking a distribution curve, the recent swift correction could be viewed as a normal retracement on a bell curve, from overbought levels to oversold levels, from their ten week trading bands, providing a refreshing pause.
A RS chart helps gauge the magnitude of a movement. When the relative strength relationship between equities and cash favors cash, the magnitude of a down move is likely to be larger. When this chart favors equities, the magnitude of the movement down is likely to be smaller. From March 2003 to November 2007, the relative strength relationship favored equities. There were multiple times during this 4 1/2 year period where the BPNYSE went into O’s but the pullbacks were brief and the Dow never declined by even 10% until late-2007.
When cash is the favored asset class dramatic pullbacks have occurred. Below is a relative strength comparison with cash and the S&P 500. Notice that cash was primarily favored from November 2007 to March of 2009. Equities became favored on March 13 2009.
Right now this relative strength relationship continues to favor equities and it makes sense not to panic. IF RS moves to favor cash more aggressive defensive actions will be considered. A best guess estimate, from the Dorsey Wright technical service I subscribe to, is that a move to the SPX to about 975 would flip the RS reading to cash.
Where is Support?
The BP indicators, measures the percent of stocks on a Point & Figure buy signal and are not directly correlated to the market indices, like the, Dow Jones [DJIA] , the S&P 500 [SPX] or the Nasdaq 100, QQQQ’s. Point and figure charts provide can some guidance were buyers might step in to support an investment.
The Dow Jones chart shows support now in the 9800 area.
The chart of the S&P 500 [SPX] shows potential support at the bottom of the ten week trading band in the 1020 to 1040 area.
For holders of the QQQQ’s, the first sell signal will come at 42.5, with some support at 41.5.
Summary
The technical’s right now are telling us to be defensive, but being defensive is a process rather than a single event. We’ve seen the first cracks in the market with the BP Indicators reversing down but RS still favor equities over cash. The market does not move in a straight line. Remember, there were numerous pullbacks from 2003 to 2007 without cash becoming favored over equities.
The charts don’t tell us what will happen so I have no idea how the markets will play out. I will be taking steps to reduce portfolio risks and keeping a close eye on the signals. I am confident that having a process in place that monitors supply and demand factors and reduces emotional reactions will avoid falling off the cliff, like we saw in 2008 and will build wealth.
Disclosure: QQQQ is a position held by Belray Clients.
According to a research paper published in The Journal of Alternative Investments^ and The Journal of Indexes**, Capturing market volatility may significantly increase diversification and increase returns.
This paper showed that if an investor with a typical portfolio added a 10% allocation to VIX futures (a measure of market volatility), the portfolio’s annualized return was improved by 3.5% while the portfolio’s risk was reduced by one third***.
Volatility is like an elevator that tends to go up when the market is going down and down when the market is going up. Unlike other asset classes, it does not actually appreciate in value or distribute any income. So while it may not be an asset in the most traditional sense, it appears to be an investment class that may provide benefits to investors.
Within our office there have been lively discussions on how to best capture the benefits of market volatility. The areas we are researching include: VIX futures, managed futures, and option strategies. In future emails I will discuss how we may be able to apply these strategies to client portfolios. – Greg
^ Edward Szado, “Vix Futures and Options: A Case Study of Portfolio Diversification During the 2008 FInancial Crisis,” The Journal of Alternative Investments (fall 2009), vol. 12
** Matt Moran, “Record-High Correlations Pose Challenges for Modern Portfolio Theory,” Journal of Indexes Jan/Feb 2010
*** Standard Deviation was the measure of portfolio risk
CNBC has been loaded with “experts” advocating that this is a traders market and that Buy and Hold is dead. There is a great article in the most recent Journal of Indexes addressing this question. I have highlighted the most important comments in the excerpts below:
John Bogle (Founder, Vanguard): I would just say very simply, of all the stupid ideas, the idea that buy-and-hold investing is dead is [the most] ridiculous. I would just ask “Buy and hold what?”
Buying and holding an individual stock has been dead forever, and buying and holding a managed portfolio is probably dying. And buying and holding the entire stock market is the way to invest in success. Then the question becomes, “Buy and hold what kind of portfolio?” I would say buy the bond market portfolio and the stock market portfolio and hold them both as long as you live, with one caveat. And that is, take into account your risk tolerance and your age. So adjust that equation—more in bonds when you’re older and more in stocks when you’re young. That idea will never die.
Diane Garnick (Investment Strategist, Invesco Ltd.): The concept of buy-and-hold is really a little bit of a misnomer. When buy-and-hold began, one of the things we were trying to communicate to people is that when the market does poorly, it’s a bad time to take all of their money out of the equity market, invest it in Treasurys and wait for things to recover. That said, the real message behind buy-and-hold was “don’t panic,” and that message is still alive.
When it comes to buy-and-hold investing, there is a subtle, but important distinction that we need to help people understand. A better message might be “invest widely and rebalance frequently.” For example, when the stock market does very well, it might be a good time to take money away from stocks and invest it in fixed income, focusing more on asset allocation rather than gains or losses in a portfolio.
Jeremy Siegel (Professor of Finance, Wharton School, University of Pennsylvania): Absolutely not! Just because we have had two major bear markets in the last decade does not nullify the buy-and-hold philosophy. Although stocks have had poor returns over the past decade, they have had annual returns over 8 percent over the past 20 years, and over 11 percent over the past 30 years, far outdistancing bonds.
Gus Sauter (CIO, Vanguard): Nothing that has happened over the last couple of years would lead us to at all conclude that a buy-and-hold strategy isn’t as valid today as it was two years or 10 years ago.
In fact, unless you can see the future—unless you know the future—buy-and-hold makes all the sense in the world. Really, the advantage of buy-and-hold is that it removes the temptation to abandon a long-term plan at just the wrong time. When the markets are going down, we all feel some degree of fear and some desire to change our strategy and get out of equities. Too frequently that happens at or near the bottom of the market.
At the same time, when markets are moving higher, there is natural human greed that kicks in to make us want to double up on our bets, or increase our equity exposure. What we’ve found is that human behavior leads us to make these changes at just the wrong times. So, a buy-and-hold strategy helps prevent us from acting in a knee-jerk fashion and under-performing because we’re making all the wrong moves at the wrong time.
Burton Malkiel (Professor of Economics, Princeton University; and CIO, AlphaShares): I think it is not dead. Obviously, after the kind of market we had in 2008, it’s very natural for people to say, “Well, obviously you should have sold during 2007 and then bought back at the bottom in March of 2009.” We all have 20/20 vision in retrospect. The problem with it is that nobody―and I repeat, nobody―can time the market.
Now, you might say, “Well, maybe individuals are emotional, but the institutions know exactly what to do.” And here, the evidence is just as clear. Mutual funds have their smallest cash positions right at the peak of the market. In other words, when you look at institutional investors’ movements of cash, you find that they do exactly the wrong thing.
So, while I understand the argument that if you could time the market you’d be much better off not being a buy-and-hold investor—since nobody can do it and when you try to do it you’re going to do the wrong thing—I think it is just extraordinarily dangerous to try to time the market. And I think no one—neither an individual nor an institution—ought to attempt to do it.
Larry Swedroe (Principal and Director of Research of BAM Advisor Services): I almost have to laugh whenever I get a question like that. It’s similar to the question, “Is diversification dead?” Whenever we get some kind of crisis, all those who believe in active management come out of the woodwork with this nonsense. All that shows is that they don’t know the basics of investing. Any student of history and investing would know that during a financial crisis that is systemic around the globe, the correlation of all risky assets always go towards 1.
There was actually an article in [the Oct. 11, 2009 issue of] Investment News, titled, “The days of buy-and-hold have gone and went.” So let’s deal with that issue.
It’s a very simple mathematical fact―which William Sharpe demonstrated in his nice little paper called “The Arithmetic of Active Management,”―that active management must lose in any environment or any asset class. Anyone who says otherwise should be required to wear a shirt that says, “I can’t add,” in big, bold letters. There are only two types of investors: active or passive. So, let’s say you are a passive investor and you just want to own Vanguard’s Total Stock Market Fund [NYSE Arca: VTI]. If the market goes up 10 percent, before expenses, you must get 10 percent, as all passive investors do. And that means, in aggregate, the active investors have to get 10 percent, before costs. The same math applies in down markets.
Since active investors have higher expenses, active investors must lose after costs. As Sharpe points out in his article, anyone who produces a study that finds anything different is simply measuring the wrong things.
Last night I watched the 1964 animated classic “Rudolph the Red-Nosed Reindeer” with my son. There is a scene where the prospector, Yukon Cornelius, sings of his search for Silver and Gold. Cornelius, where have you been? We found it.
RiverSource Precious Metals and Mining Fund [Ticker: INPMX]
Market Vectors Gold Miners [Ticker: GDX]
Coeur d’Alene Mines Corporation [Ticker: CDE]
Silver Standard Resources Inc. [Ticker: SSRI]
These positions are notable for a reason—they are investments in precious metal mining companies.
If you are a client, the RiverSource fund may look familiar. You have had a position since November 2008, and (depending on the exact entry date) the position has a gain of anywhere between 80% and 110%. If you are a newer client, the RiverSource fund was one of your fist investments, and you will notice that it has outperformed virtually all other investments and indices.
Within the past three weeks you have seen the addition of one of the other three securities to your portfolio. Market Vectors Gold Miners overlaps the RiverSource Fund to a degree, but adds additional companies. Its purpose is to add concentration in the mining sector, with further diversification.
Coeur d’ Alene Mines and Silver Standard are not funds; they are individual companies. Neither of them is part of the portfolio of the aforementioned funds. There are several interesting characteristics of these two companies. Firstly, they are “junior” miners, i.e. they are small compared to the major players. Many “juniors” do not have productive mines, but these two do. Silver Standard is strictly a silver miner. Coeur mines both silver and gold, and it is the only junior to do so. Being smaller companies, their capability to grow is greatly enhanced. They are a riskier investment, but circumstances are aligning in their favor.
Okay, that is all fine, but why the all the attention to mining companies? Furthermore, why the addition to this sector when it has already doubled in value over the past year? Has this train run its course, and the ride is over? Don’t fret, there is still a lot of mileage left in this three-legged trip. We were saying that as gold broke a $1,000/ounce, and we’re saying it now.
The first leg was powered by fear, brought on by the credit crisis. In times of uncertainty people seek stability, and nothing is secure if not gold. Its practical uses are very limited, but it is still one of the most sought after commodities in the history of man. Wars are waged, empires are built, and the [New] world is divided over it, just ask the Spaniards or the Portuguese. Its purpose is simple: currency, storage of wealth. It is no coincidence that people preparing for disasters do not stockpile Dollars or Euros, they stockpile gold. Did you know that the entire supply of gold extracted throughout human history could fit into 2 Olympic-sized swimming pools? It is indeed a rare metal.
The second leg of this trip has just started to leave the station, but the whistle has been screeching “All Aboard!” for an entire year. This, of course, is the weakening of the US Dollar (USD). Gold is priced in USD. As the Dollar gets weaker, the price of gold increases. Think of it this way. $1,213 buys an ounce of gold, today. If tomorrow the dollar becomes weaker as a currency, the gold seller will require more of the weaker currency to buy the same troy ounce of gold. After all, the dollar just doesn’t go as far as it used to. This Administration and Congress are going to do everything in their authority and beyond to guarantee that our dollar continues to weaken. We’re going to take that to the bank, since this message has been extremely clear, and the obvious is now coming to fruition. Those of you that remember 1982, standby, things are going to get a lot more expensive.
The final portion of the gold trip is not as certain, but has potential. Leveraged, producing companies have recovered well over the past 10 months. Commodities have also recovered, but not to the same degree. If the economy is truly working out of a slump, then real assets will resume their secular bull market that was curtailed by the credit crisis. There is a lot of potential waiting to advance, but we need confirmation beyond the Beltway. Either way, the path for precious metals is smoothly paved. If the recovery is real, commodities recover, silver (the industrial precious metal) is in demand, and all is well. If the recovery pans, then fear resumes, the Fed prints money, more lose jobs, inflation ensues, and gold advances, as does silver. Not a pretty economic picture, but we’re prepared.
Precious metal miners are included in your portfolio under the category I describe as “aggressive growth.” Their volatility is extreme. At the end of this past October they lost 11.5% in a single week (your investment dived that much in 7 days—and a couple of clients took note!), only to climb over 25% in the following 5 weeks. Being so volatile, the portion of the portfolio we invest here needs to be prudently limited. As a portfolio manager, I reserve 5% of the portfolio for “niche opportunities,” and this is one of them—right now. The argument to load-the-boat is compelling, but I am cautious of the unanticipated, and we have an adherence to investing discipline. Watch for gains in your mining stocks over the following quarters, but also be aware that they will not come without volatility.
As a little teaser: perhaps another individual stock will be added to your portfolio (under the “niche opportunity” category) within the coming days as I conclude research.
Disclosure: Belray clients are long INPMX, GDX, CDE, and SSRI.
