S&P 500 Index 1605
By Steve Blumenthal
July 3, 2013
Investor Sentiment dropped into the Extreme Pessimism zone over the past week and has since moved back into the Neutral zone. This is a statistically positive event as evidenced by the 15.1% gain/annum. There is good support at 1560 on the S&P 500 Index. The cyclical bull trend remains in place.
Following is the most recent Investor Sentiment chart, and two cyclical bull charts reflecting the current cyclical bullish trend (watch these), and technical charts indicating points of logical short-term support in the S&P 500 index.
Investment Sentiment charts 7-2-2013:
Chart 1. NDR Crowd Sentiment Poll – Neutral from Below
Investor Sentiment has moved into the neutral zone from below 57. I favor removing hedges at points of Extreme Pessimism. This happened over the last week. I intend to get more aggressive in my 401k on the next market decline (hopefully a test of 1560-1580 support area). The cyclical bullish trend remains in place as reflected on the next two charts.
Cyclical Trend Chart 1: The 13-week EMA over 34-week EMA chart continues to reflect a cyclical bull up trend as the 13-week EMA (blue line) remains above the 34-week EMA (red line).
Note how well it has identified the major cyclical bear and bull market periods. Cyclical bull trend is still intact.
Cyclical Trend Chart 2: Big Mo: The trend as measured by Big Mo also remains bullish.
Following is the data on buy and sell signals.
Technical Support – I’m watching the following levels (as presented in last week’s Trade Signals):
Pessimism was just fractionally reached. I suspect another test of the break of the May low is ahead of us. The support at the March 2000 high and the 2007 market high of 1575 is immediate market support. The next level of support is at 1536 (April’s low) and 1482-1500 (the 38.2% retracement of the November 2011 low to the May 2013 high and also the current 200 day MA). I’m more constructive on a continuation of the cyclical bull market up trend given the timing of the Extreme Pessimism reading and the test of market support in the 1560 – 1580 area.
I recommend removing hedges or consider holding deep out of the money puts (inexpensive) for tail risk protection.
The market remains in a cyclical bull market up trend. I also believe we are in a period of time that favors proactive risk management (hedging your long equity exposure). I like timing entry and exits tied to both investor sentiment and logical support and resistance levels. Extreme Pessimism was reached last week tied to support at 1560-1580. This is positive sign for the continuation of the cyclical bull market move.
Please note the comments at the bottom of this Trade Signals discussing a collared option strategy to hedge equity exposure using investor sentiment extremes is a guide to entry and exit.
Have a wonderful 4th of July!
With warm regards,
Steve
Stephen B. Blumenthal
Founder & CEO
CMG Capital Management Group, Inc.
Philadelphia – King of Prussia, PA
steve@cmgwealth.com
610-989-9090 Phone
I continue to favor a hedged approach towards long equity positions put in place from time to time tied to Investor Sentiment extremes. The cost of collared option protection (selling out of the money covered calls and buying out of the money puts) is relatively nominal compared to the potential downside market risks. I am looking for Extreme Pessimism Sentiment readings tied to logical technical support (1440-1460 first support area) as a point to remove the option hedge.
33/33/34 – My broader view is outlined in a piece called The Portfolio Construction Game Plan for 2013.
Modern Portfolio Theory is alive and well. The problem is that most portfolios do not include a broad enough set of important risk diversifiers and far too many individual investors chase into and out of the stock and bond market.
60/40 is not diversified in a low yield, low dividend, relatively high PE valuation world, yet those asset categories are important within the construct of a broadly diversified investment portfolio and the risks can be inexpensively hedged from time to time.
To me, a balanced portfolio today is comprised of 33% Equity (hedged from time to time), 33% Fixed Income (tactically managed) and 34% Tactical-Trading-Alternatives. Of course, you may allocate differently based on your risk level, age, needs, time horizon, etc.
The forward projected 60/40 expected return of just 4.37% is the lowest expected return in the last 14 decades. Source: Expected Returns – Research Affiliates. Here is a link to the Expected Return charts on our website.
The good news is that there remain ways to drive returns. I believe portfolios can be constructed in such a way as to drive return whether one is correct or incorrect in his forward view. I favor a broader allocation of 33/33/34 that includes an allocation to tactical and other liquid alternative investments. Endowments have managed towards broader diversification for years and I believe the approach better captures the core principals of Modern Portfolio Theory (MPT).
MPT is “a mathematical formulation of the concept of diversification in investing with the aim of seeking a diversification of investment assets that has collectively lower risk than any individual asset”. 60/40 falls exceedingly short of meeting this definition.
Given the global macro risks that exist today, as well as the relatively high valuations, low dividend yields and low interest rates, some form of proactive risk management makes sense to me. One day soon (maybe within the next five years), PEs will be much lower, dividend yields will be much higher and interest rates will be much higher.
Opportunity will present itself in a period of crisis and while others are panicking out, you’ll be in a position to capitalize. Until then, I favor a broader portfolio construction approach (33/33/34) that includes a disciplined hedging strategy to protect the long-term focused equity portion of your portfolio(s).
Trade Signals was created with the intention of providing a disciplined process to hedge the long-term equity portion of a well diversified portfolio. You will be right from time to time and look like a genius in those moments and, frankly, you will also be wrong from time to time and look less than spectacular. I am far less concerned about getting a short-term directional call correct. I am more concerned about making money. For me, it is about inexpensive risk management in a high risk world. The cost of protection is nominal if executed correctly.
Investor sentiment indicators have helped me over the years and I hope that the statistical math behind investor sentiment extremes (human behavior) can help enhance the risk management of the equity portion of your portfolio(s) as well.
Overview: A disciplined equity hedge – risk management approach
Several times each year investor emotion reaches levels of Excessive Optimism and several times each year emotions reach levels of Extreme Pessimism. A strategy idea I favor is a disciplined risk management equity (hedge) approach as it relates to the long-term equity portion of a portfolio. Initiate hedges when investor sentiment reaches Excessive Optimism and remove hedges at periods of Extreme Pessimism.
A collared option strategy which involves writing covered out of the money calls and at the same time buying out of the money puts is something to consider. It is a relatively inexpensive hedge approach and allows your client to stay on plan with their long-term equity exposure. The game plan is to implement the hedge just a few times each year tied to sentiment extremes. Today is one such extreme. Then remove hedges tied to Extreme Pessimism. Go to www.cboe.com and search for “collared option strategy” to learn more. I favor selling 5% out of the money calls and buying 5% out of the money puts with maturities several months out. It is important to manage to your risk tolerances/investment objectives but at most budget spending a small percentage of your equity exposure each year.
Given the overbought extremely optimistic nature of the market today, I believe spending a small amount of money to protect that long exposure is prudent.
Please note that this is absolutely not a recommendation to buy or sell any security. For discussion purposes only.
A note on active hedging
Within the long-term secular bear environment I believe we are in, I favor hedging the long-term equity portfolio exposure tied to periods of Extreme Optimism and removing those hedges tied to periods of Extreme Pessimism. As you can see in the above charts, there are just a few times each year that the market moves into “Extreme”. I like put options and covered calls against long equity exposure. Never sell “naked” put or call options. Another idea is to budget a percentage of your long equity exposure to actively put on and take off exposure to a leveraged inverse index based ETF.
I believe that we are in a period of time which favors actively hedging long equity exposure. I like putting hedges on when investors are extremely optimistic and removing hedges when investors are extremely pessimistic. The focus on the long equity portion of your portfolio is to enhance return, reduce risk and preserve capital. Go to www.cboe.com to learn more about options. All investments involve risk.
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