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.