This post is an expansion of a 10 tweet thread posted on 3/12
by @survive_thrive on Twitter.
2018 has been a very interesting year for the stock market.
We have seen market perform amazingly in January, one of the best January on
record but soon gave back all the gains in a period of 10 days.
This decline was
accompanied by explosion of volatility, which caused many funds to experience their
worst draw-down in decades. At the same time, many novice and experienced
investors who were betting against VIX for years and had generated impressive
gains over past few years were wiped out in 1 trading session.
This volatility and wipe-out highlights the importance of a
well-balanced portfolio that can generate returns under different market
conditions. Such portfolio construction cannot be accomplished by just following
the market pundits on TV because they are paid to react to market rather than
being level-headed, which could also be boring. We prefer being boring and
consistent because long-term gains are dependent on lower draw-down than
temporary rally.
In order to be level-headed, one needs to consider the
market at its merits and dissect different aspects of the markets.
Currently, the stocks are at a very interesting point. Nasdaq recently
reached all time highs while SP500 recouped most of early February decline.
This development was significant enough to attract many prominent financial
analysts on financial media and twitter to proclaim continuation of the
uptrend. However, we remained cautious of this rally because of multiple reasons.
First of all, DJIA alongside other US and global indices
have been rallying since 2016 (2 years) with a rather sharp rally since Nov 2016 US
elections. This behavior is inherently unsustainable. Nothing goes straight-up.
Similarly, nothing goes down in a straight line as well. If a new rally phase starts at this point, it would
mean that this rally would continue for few more months without a major
correction. This kind of behavior, while possible, is highly unlikely.
Secondly, we received a proprietary sell signal at the end
of Jan. This signal was used previously but this is the first time we are using
it in actual portfolio allocation. This sell signal is a predictive signal and therefore,
helps us in pre-empting the risk. However, it doesn’t mean that we have entered
a new bear market. On the contrary, as per our bull/bear model, we remain in a
bull market with strong momentum.
Thirdly, recent rally resulted in divergences. A divergence
occurs when one index reaches a new high but is not accompanied by other
indices. This shows reduced leadership, and signals weakness.
Fourthly, bond market has been declining since June 2016. And
now we are hearing from many pundits that the long-term Bond Bull market has
ended, and this is also evident from heavily short positions. As the sentiment
sours towards Bonds, we approach a critical decision point in Bonds:
- Resumption of the rally: This possibility is supported by following observations –
- Proprietary buy signal
- Heavily negative sentiment towards Bonds
- Confirmation of the Bear market
- Very close to confirming a bear market
While we could enter a full blow Bond bull market, its
possibility remains lower. And even if we do enter a bear market, we will have
many more opportunities on the short-side.
Keeping the above reasons in mind, we have established a
very small (less than 10%) short position in the US stocks. This position will
be active for few months till we receive another signal or this signal expires.
Because we did not enter the short position right at the top because of reason
mentioned earlier, we were underwater for some time but now are again in the
green. And look forward to further gains.
However, one should keep in mind that investing against the
primary trend is a dangerous game. Since the trend remains higher, our position
size remains small and is supported by key sell signals.
Under such circumstances, our portfolio remains
risk-neutral. Following chart shows the performance of our portfolio with
respect to SP500. Our goal has never been to always beat the market. Instead, it is to reduce volatility and maximize long-term gains. We hope that soon this sideways action will resolve to the
upside and generate the expected gains that we have seen in past years, while minimizing the downside risk.
