Interesting Market Circumstances

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:

1.  Resumption of the rally: This possibility is supported by following observations –
1. Proprietary buy signal
2. Heavily negative sentiment towards Bonds
2. Confirmation of the Bear market   
1. 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.