Discipline

At ValueTrend, we utilize two distinct disciplines in our process. Foremost, we are macro-driven managers, meaning that we place great emphasis on some specific macro trend indicators that suggest whether general market conditions are higher or lower in risk at any time. As I’ve noted before—it’s all about probability and risk. It not about being absolutely sure about anything—that is, we don’t know for sure what is going to happen, but we do know how to measure the probabilities. Among those indicators are:

• Trend (more on this in a moment)- this is our most important indicator
• Seasonality – for both macro and sector probability tenancies
• Sentiment – are market players overly optimistic or pessimistic – and if so—who (i.e. “smart” investors or “dumb investors”) is optimistic vs. pessimistic?
• Market breadth—how much participation in a market movement is occurring—is it concentrated or is it a broad based movement?
• Volatility—is the market showing wide swings or is it fairly benign?
• Valuation—is the market cheap, expensive or somewhere in the middle?

I’ve touched on some of the indicators I use to study the above factors in past blogs. Today, I want to focus on that most basic tool of technical analysis–the current macro trend – which is the most important factor I study. By looking at the chart below, you will see why I have been holding cash in the equity model, and why I went defensive in January – despite the seemingly wonderful rally seen in the past few weeks – and despite the normally positive seasonal factors for markets at this time of the year.

My basic trend analysis technique is pretty simple. I’ve covered it in this blog before, and I’ve covered it extensively in my book, Sideways.  Lets review it quickly

• For a market to be in an uptrend, its weekly chart must be making higher highs, AND higher lows.
• It must be above its 200 day (40 week) moving average- which is the green line on the chart
• If the market takes out a low and forms a lower low, without having made a higher high – it is suspect for breaking trend. However, it could be just moving sideways. Case in point, the entirety of 2015 was a case of no new highs or lows and a one-time break of the moving average. We were out of the market (50% cash) when that happened in the spring of 2015.
• For the market to be in a downtrend, it must be making lower lows AND lower highs.
• It must be below its 200 day (40 week) MA

On the chart below, I’ve drawn the highs and lows and coinciding 200 day moving average breaks with arrows to show buy and sell signals since the 2008 crash. Note that ALL conditions (new low or new high AND a moving average break) must be met to signal a buy or sell. Note how the signals, while sometimes a bit whippy, saved our bacon (so to speak) in 2008, and got us in again later in 2009.

How this applies to today’s markets

The market moved back above its 200 day moving average in the fall of 2015. After holding cash raised over the spring, we went fully back into the market in October. By January (talk about a wild ride…) the market once again broke down through the moving average—AND it put in a lower low. We were forced to sell again–although not as aggressively (current cash is 35% vs. 52% last summer). Markets fell in January and the first half of February. Suddenly, it reversed and rallied – and has since then come right back to the 200 day moving average. The wild ride continues.

The market has NOT seen a higher high since last May. According to our trend rules: Officially, the market is now in a bear market until BOTH the 200 day MA is cracked (which is looking to be the case as I write this) AND a new high is achieved. So, despite the seemingly wonderful rally over the past few weeks, we should view the market as a shorter termed bull within an intermediate termed bear. The above conditions (break of the 200 day MA and a higher high) may occur in a week, a month, a year or a decade. That doesn’t matter. My rules, which you are free to dismiss, suggest holding some cash at this time.

“The future isn’t a predetermined scenario that’s sure to unfold, but rather a range of possibilities, any one of which may happen. Investors formulate opinions as to which of them will happen. Those opinions may be well-reasoned or dart throws. But even the most rigorously derived view of the future is far from sure to  be right. Many other things may happen instead.”

Howard Marks, Oaktree Capital