Model Performance - March 23, 2016

First of all, I would like to apologize for not being active on the blog over the past several months. I just passed a certification exam for which I had been studying. Now that I have some time, my goals are to share market / economic analysis on a regular basis.

Markets have rallied over the past month with a vengeance. On one hand this rally brought SP500 and DJIA back into green and improved sentiment, it also masked underlying economic uncertainties.

On Feb 11th, we knew a rally was coming based on Elliott Wave analysis. However, the problem with counter trend rallies is that there is no clear end point. This is exactly what has happened with the market over the past few weeks. This rally was very sharp, similar to rally in October 2015.

Since we tried to build-in many risk-management, trend following and asset allocation characteristics in the algorithm. As a result, the model portfolio did not undergo any significant changes during the rally. And even without changes, overall portfolio performance remained stable. 

As shown below, the portfolio is up ~5% (YTD) while SP500 is up only 0.28% during the same period. This result was obtained with half the Beta risk, as one would take if you had invested in SP500. In other words, risk adjusted returns has beaten the market by over 10%, during a market which remained flat over time with sharp market moves.

If the primary trends resumes, portfolio is well positioned to benefit from the price movement with strict risk-management features. 

Portfolio Performance

As market rallied over the past week or so, the portfolio declined. As you know the portfolio has a Beta of -0.5 and therefore, it minimizes risk in a down trending market. However, when market rallies, the portfolio doesn't do as well. One of the inherent abilities of this portfolio is to mitigate risk and follow trend.

As a result, if the trend reverses in any of the underlying portfolio components, it will adjust accordingly. Therefore, if the market trend changes from Bear to Bull, we will re-adjust based on proprietary model. This will bring the Beta into positive territory, enabling us to participate in the uptrend.

For now trend remains down. We have been discussing a bear market potential since last August and recent decline has prompted many market gurus to agree with us. However, sharp rally of the past few weeks forced many investors back into the market. But I am afraid it will be too early.

I know it can be nerve wrecking to stand on the sidelines and see the market rally. The problem is that one feels like he/she is missing on great long-term buying opportunity, only to find out that that opportunity was nothing but a bear market rally. Bear market rallies are very sharp and can suck-in many investors.

Therefore, it's best to let the market confirm its direction before jumping in. There are many ways to confirm a trend and I have analyzed following ways very extensively over the past 6 years:

1. Elliott Waves
2. Patterns
3. Technical Analysis
4. Indicators
5. Fundamental analysis based on value, CAPE or dividend percentage
6. Sentiment
7. Proprietary model

Although these are good techniques and have solid foundation around them, no single method can be regarded as 100% accurate or even close to 100%. Therefore, we decided to automate portfolio allocation and combine above mentioned strategies in an automated algorithm to remove emotional aspects out of investing. So far the portfolio has performed very well.

We are in process of back-testing the portfolio. Will share results over the next few weeks. 

Portfolio Performance and Market

Today's market action was choppy and classic corrective. Market is trying to digest the decline, before the next leg down.

However, keep in mind that this sell-off is getting stretched and the Elliott Wave pattern suggests that we have couple of stair-steps down before we can see another rally. This rally might come in early March.

Some of the readers might have forgotten how it feels in a bear market. But think of it as inversion of a bull markets: Bull markets go up with quick down moves as corrections; Bear market decline over time with mini rallies as corrections.

Over the next few days, we will have some significant earnings reports from DIS and Cisco. If  Disney falls on a strong earnings report, it would further help categorize the market and its nature i.e. Bear Market.

In financial markets the best approach to invest is to follow the trend because in a downtrend, good news will result in bad market reaction and in an uptrend, bad results will result in strong market action.

In order to automate trend following and ensure risk-management aspects of the portfolio, we have incorporated some critical portfolio management aspects into an algorithm. The portfolio performance based on this algorithm is shown below:

We will keep updating the performance of this portfolio on this blog. This is a simplified portfolio with few holdings, low turn over rate and Beta of -0.5. Therefore, it reduces the portfolio correlation risk with the market, ensures effective risk-management and allows for dividend payments over time.

As market dynamics change, the portfolio will undergo tactical and strategic adjustments to optimize performance across different market conditions and asset classes. We are closely looking at other asset classes to identify upcoming investment opportunities, which will be automatically added.

Employment Numbers, Economy and Market

Economy continues to perform below expectations. Latest job numbers were OK but not GREAT. I don't think they are even good enough to justify future rate hikes. But unfortunately Federal Reserves is locked into this situation where they have already committed several rate hikes for 2016. Although they won't do four hikes in 2016, any hikes will result in a flattening yield curve and possibly lead to negative yield curve.

Yield curve inversion typically leads to a recession. Although the numbers are not showing eminent recession right now, the stock market is now surely discounting a significant slowdown in economic activity. If the economy is to enter a recession, we could see further losses in the market.

From a socioeconomic perspective, a recession/bear market in the final year of election, could pave the path for a socialist president in the form of Bernie Sanders because people will be angry towards capitalists.

Getting back to economy, industrial activity has slowed considerably, which is an indication that the manufacturing sector is already in a recession. Number of job cuts being announced reminds us of the days of the great recession, when the news was always about reduction in workforce. When you have job-cuts coupled with tightening Fed policy, restricting the money flow, it just exacerbates the economic situations.

In fact, it leads the economy into a death spiral where one negative news feeds the other negative thing and so the cycle continues. For example, reduction in jobs will result in lower spending, which will in turn reduce profits, resulting in lower stock prices and cost-cutting measures, which will result in more job-cuts.

Under these circumstances, stock market is tracing out a series of mini-head and shoulders patterns. As you know head and shoulders pattern are topping formation. These patterns also appear in a downtrend as continuation patterns. Following chart shows H&S pattern in SP500.

If market declines in the next few days, this pattern will be broken and January lows will be tested. This will allow the market to complete the right shoulder of a longer-term head and shoulders pattern (discussed here)

Under these circumstances, the best option is to stay out of the market and wait for a trend change before going long again. Bonds remain in a bull market, so they can be a good place to park cash and ride-out this rough patch in the stocks, which could last for the next few quarters (at least).

Downtrend Continues

Market resumed its decline in a major way today. More interesting than the decline was the muted reaction from the traders, as VIX did not spike. If fear doesn't spike with declines, it means that we have further decline ahead.

Market rallied last week but got way over-bought in just few days. In fact, a sell signal was generated on Friday. That sell signal resulted in decline yesterday from which the market initially recovered. However, it was too much weight for the market to carry. As a result, it gave way to serious selling today.

We have been maintaining that the stock market's inherent structure changed last year in August, and suggested a move to cash. Proprietary portfolio allocation model allowed us to diversify between bonds and short stocks. This portfolio has been performing very well so far this year (link). It is up +6.7% this year, while SP500 is down 6.7% this year. We will talk about latest results in the next post. Right mow, let's look at the structure of the market.

Nasdaq along with many other indices, is tracing out another head and shoulders pattern. This pattern is larger in magnitude than the prior pattern, and could result in substantial decline.

Over the next few days, market will fill the right shoulder of this pattern. Once right shoulder is filled and market breaks below the neck-line, significant decline can be in the offering.

Head and Shoulders are reversal patterns, and when you see a cluster of these patterns, as shown above, they become even more important. Overall, it means that the trend of the last 7 years has ended and we have entered a bear market. This would mean that the economy will slow down and we might see additional bad news coming from different market segments. Oil was the initial catalyst but now we could see other areas hurting.

However, many people are just realizing this new development and others are still oblivious to a market decline. But we prepared for this potential scenario and now are waiting for the downtrend to unfold over the next few months. Bonds remain in a bull market, as yields continue to decline.

Portfolio Performance & Market Overview

Market remains in a bear market. Sharp rally of last weak as the feel of a bear market rally. Today's decline might be the start of next leg down. However, this leg might not be as long as what we saw in early January. In fact, once this phase is over, we could see a sharper rally, lasting for 2-3 weeks.

Although the above analysis is based on Elliott Wave theory, overall trend remains down. And till the time this trend turns up, we should remain cautious. Our portfolio allocation model exited long positions in August. And shorted the market at the start of 2016.

So far the portfolio is up ~5% (YTD) in comparison with ~8% (YTD) decline in the SP500. Another interesting aspect of this portfolio is that its "Beta - measure of risk when compared to SP500" is -0.56. 

Therefore, it is not correlated to the market. In a bear market, this portfolio mix not only allows us to gain from the market decline, but also enables us to protect ourselves in case of a sharp rally (like the one we saw last week).

This portfolio is an auto-allocation portfolio with diversity considerations to ensure protection against systematic risks. Asset class risk is managed by employing proprietary Bull/Bear identification mechanisms. We will keep tracking this portfolio on an on-going basis to see how it performs over the long-term. This portfolio can also be considered as the next step in our effort since March 2015 to automate portfolio management through advanced analytical and statistical tools.

As for the overall market, their is no change in the outlook. Stocks remain in a bear, while bonds remain in Bull market. There are some asset classes which have just entered a Bull market or are trying to carve not a base before entering the next phase (Oil is not one of them).

Stock Market Trend and Russell 2000

We have been discussing market and its down trend for quite some time at Understand, Survive and Thrive. It seems like this relentless downtrend doesn't want to end any time soon. Oil keeps on falling and keeps dragging the stock market with it. At some point market will rally but in a downtrend one cannot trust the rallies. In fact, hoping for a rally in a bear market is akin to hoping for a correction in a bull market.

Rallies will come but will be short and sweet. By the time people embrace them, they will be over and the primary trend will resume. One of the biggest red flag in current market is the significant under performance of Russell 2000. Russell 2000 is a small caps index and small caps are most impacted by changes in economic conditions because they are most sensitive to credit availability.

These business depend on economic growth and easy credit for their survival. Therefore, whenever you see small caps declining, its a major red flag.

In December, we highlighted that Russell 2000 ($IWM) was forming a head and shoulders topping pattern (link). The pattern looked like:

Now a completed pattern looks like following. This pattern still has another 7% decline left before it reaches its measured target level.

Small caps are already in official bear market, another 7% decline will bring the Russell 2K index in low 900s.

This analysis shows the importance of objectivity in investing and why trend following is critical. An up-trending market will find excuses to go up and a down-trending market will find fundamental and technical excuses to go down.

At this time, long-term trend in stocks is down. So every rally attempt should be treated with caution. Downtrends implication are very severe on the economy. We might be headed for a recession. Junk bonds and oil related bonds are doing poorly. This could be another area of serious concern. We will continue to evaluate the situation. But the bottom line is the best portfolio right now will be a portfolio who beta is lower than the SP500. Lower beta would reduce your risk in a down market and will allow you to preserve capital.

In the next few blog posts, I will share our portfolio which is a -0.56 beta and is beating the market since the start of the year.