The recent rally is looking very long in the tooth. Factors such as:
- Overbought momentum indicators (see RSI, Stochastics on chart above).
- Sentiment readings are becoming overbought (Rydex beta ratio shows a big flow into high beta funds and out of lower beta funds, put/call ratios are toying with high levels, “smart money/dumb money” studies show odd lot and speculators are moving into the market, etc).
- The first level resistance on the S&P 500 at just over 1420 is just around the corner
- Dow transports were, at least up until very recently, diverging (underperforming) the industrials—see chart below
- Low volume means low conviction to the current rally
- An uninspiring recent earnings season
- Seasonality for markets is weak in September and early October, plus electoral patterns for weakness from September to November in an election year
It is my opinion that the current rally, which I did play, is based on the possibility of Federal Reserve monetary stimulation. Based on past patterns, stimulus programs by the Fed have not been implemented in September, so the market may be in for some disappointment if participants are counting on a Fed-based rally. The last stimulus programs were introduced in November 2008 (QE1), November 2010 (QE2), and October 2011 (Operation Twist). This is one more reason why I believe the current rally won’t last – markets are betting on stimulus happening sooner than it might actually occur. As an aside, recently I heard a talking head on the radio call the summer rally on the US markets a “melt up”. This term is one of those newly popular cliché’s that tend to become popular in business circles. Business people use them in an attempt to sound witty or intelligent. I’d like to motion a bill to punish those who make up or use these annoying terms.
How to hedge your risk
The obvious way to hedge risk out of an equity portfolio is to reduce your equity exposure. You can do this by selling your most vulnerable positions (technically weaker) and raising cash. The other way to reduce risk is to hedge it out with a “neutralizing” strategy. This can involve buying an element of an inverse ETF’s for the portfolio, or buying securities that might actually benefit from a market decline (treasury bonds, short positions, etc).
I was on BNN’s Market Call show last Friday, where I presented a unique ETF for hedging equity portfolio risk. I’d encourage you to view the show—particularly the final segment where I present my current top picks to learn more about this hedging strategy. I’d also be interested in hearing about hedging techniques that readers are using or have used successfully in the past to reduce portfolio risk.
On a final note, I am on BNN again for a quick morning commentary with Frances Horodelski on Thursday at 10:30 AM. I’m not sure what I’ll cover at that point, so let’s just say I’ll address the markets from the perspective of the market currents at that time.
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“LOOKING AT EQUITY MARKETS, THE BULLISH TREND IS SHOWING SIGNS OF IMPROVING.” (EQUITY CLOCK, AUGUST 20, 2012)
RISK SENTIMENT CONTINUES TO IMPROVES SUCH AS THE RUSSELL 2000 SMALL CAP INDEX.
CYCLICAL SECTORS, SUCH AS ENERGY AND INDUSTRIALS, ARE LEADING THE MARKET HIGHER (…) WHILE DEFENSIVE SECTORS ARE LAGGING MARKET PERFORMANCE.
BREADTH IS ALSO SHOWING SIGNS OF IMPROVEMENT, THE S&P EQUALLY WEIGHTED INDEX IS STARTING TO OUTPACE THE CAPITALIZATION WEIGHTED INDEX AND THE CUMULATIVE ADVANCE-DECLINE LINE ACROSS THE BENCHMARKS ARE ALSO IMPROVING.
A RECENT SETUP IN THE US DOLLAR INDEX SUGGESTS THAT EQUITY MARKETS MAY STILL HAVE A LITTLE WAY TO GO BEFORE TOPPING OUT. THE CURRENCY CONTINUES TO SHOW A SHORT-TERM HEAD-AND-SHOULDERS TOP COMBINED WITH A BEAR-FLAG FORMATION. (…)
I agree that the markets may still have a little way to go before topping out–the question is, how much more? Thus, my observations are more of a heads-up for September.
Personally, I have raised my equity model to 33% cash over the past number of trading days. I am reducing my risk, but not yet ready to hedge. As mentioned on the BNN show Friday, I will hedge if as and when the momentum indicators round over. Meanwhile, I am comfortable holding some cash.
Note also that when everyone was bearish 2 months ago, I was going against the crowd by holding 90% long equity. Now, the sentiment studies (and talking heads) are becoming much more bullish, per this weeks blog. Thus, I am inclined to begin taking a bit off of the table. There are a few managers who I respect in the same camp, including Don & Brooke (60% + cash in HAC).
I was examining the AAII sentiment survey and it seems when the Bullish percent gets into the high 30’s and 40’s and remains there for several weeks it seems to indicate at least the start of a top in the markets. Having said that, the bullish percent has only in the last two weeks approached the high thirty’s so I suspect it will take several weeks to form a top and then we may begin to roll over. Which aligns nicely for your call to be cautious into Sept and Oct. It almost looks like a short squeeze happening up until then. I guess it is true that forming a top is a process not an exact point in time
Precisely!
One observation I have made with sentiment indicators is that they are often leading (not coincidental) indicators, and like momentum studies can stay overbought for a while before the markets change direction.
I wrote my thesis for my CMT on combining momentum indicators with sentiment indicators. My findings were that when the 2 reached overbought levels concurrently (eg RSI with Put/Call), the signal was very accurate and timely. We are currently just under my signal levels, so there is room for a bit more upside, although the risk/reward is getting less & less attractive.
the trend line for the the S&P from it’s all time high in 2007 to it’s April high in 2012 was supportive today as it bounce right off of it. I would not be bearish until it gets below this line
Dave–I’m calling for a correction (8-10% from highs) that lines up with Seasonality, electoral patterns and sentiment/momentum signals/patterns. Not an outright bear market just yet (although that may be in the cards in late 2013).
“despite the significant dollar decline over the past two sessions, equity market have failed to move higher, hinting of equity market exhaustion at current overbought levels.” (…)
“Bond yields fell in what was the largest move lower since may. The 10 year yield bounced firmly off of its 200-day moving average, rolling over from overbought territory.”
“Put-call ratio, ended close to neutral at .97. the ratio has recently broken out of a falling wedge pattern, suggesting a change of trend fron bullish to neutral/bearish may becoming realized.” (equity clock, august 23)
Would downside target be at trendline support (1360) on S&P? Maryanne Bartels (Merrill Lynch) expects U.S. equity markets to decline 8-10% by the end of September.
1360 or so is my first downside target. If things got bad–1300 for the S&P
Hey Keith,
Great article, I’m going to try to turn in and watch you tomorrow morning.
I was wondering if you had read the article from CNBC about dollar volume. Basically the article states that while equity volumes are significantly off, the dollar volume of shares being traded is not that far from the norm.
The author states anecdotally that since shares are up 40-50% since 2008, the same share volume of 2008 would be worth 40% more today. It’s simplistic, and I believe the article is focused more on retail than HFT’s.
It also kind of makes sense that if HFT’s are 70% of the transactions, they are sitting on their butts right now with low volatility during the days. They are probably scalping the bid/ask and I bet it is taking time to get their orders filled.
Thats interesting–in this case, you want to watch “moneyflow” rather than old fashioned volume.
I guess I’m a retro kinda guy–I look at volume, but thats not to say its not better to look at a moneyflow indicator. Taking a quick look at a basic moneyflow indicator, it shows rising moneyflow earlier this year, followed by relatively flat to bearish moneyflow since April.
Canadian banks/ZEB – I sold day b/4 the earnings any rush to buy back after todays sell off and before Fed. Also, gold/silver bullion I am going with a half position – Fed. may dissapoint but Draghi on Saturday may give us enough.
Your comments will be appreciated.
Khokon
I am long the banks via ZEB, as mentioned on my BNN “top picks” MarketCall show. I did mention that there will be volatility if the markets sell off, but I bought at $16.80, and I expect that one way or another the banks will be higher by year-end, after any pullback in the next month or two.
I am also long gold, and expect to hold this position for the time being.