S&P 500 Index 1485
By Steve Blumenthal
January 17, 2013
“RISK OFF”: Raise Cash – Hedge (Investor Sentiment is once again at Extreme Optimism)
After watching the market post double-digit returns last year, Americans are pouring billions of dollars into stocks. Why now I wonder?
Just over $22 billion flowed into long-term equity mutual funds and exchange traded funds in the week ending January 9, according to Bank of America Merrill Lynch. That was the second highest amount on record after the $22.8 billion that went into all equity funds in September 2007.
It happens again and again. Behaviorally, we humans feel most comfortable and confident after a large market move. Feeling safe and projecting yesterday’s returns forward, we jump in. As a trader, I have learned to pay attention to what I am feeling and go against my emotions at points of emotional extreme. Today I feel good, really good, and since investor sentiment is at extreme optimism, I’m getting out (moving my 401k to a defensive position and hedging long equity exposure). This gut awareness didn’t happen overnight. After 30 years in this business, I can share that I have some scars to prove it. Fortunately, investor sentiment is measurable and I have found it to be an invaluable investment tool.
Could I be wrong this time? Absolutely, but the probabilities are in my favor and I can patiently wait for an attractive re-entry. We’ll reach a point of extreme investor pessimism again in the near future and I’ll rebalance my 401k then. Today, risk is elevated and I simply don’t believe the current environment of low dividend yields, low inflation and record low bond yields as an attractive time to invest. Thus, I favor active hedging and a meaningful allocation to tactical strategies.
Until valuation metrics reach an attractive level with another long-term bull market run, I believe that hedging long equity exposure at times of extreme optimism (or raising cash), tactically managing fixed income and adding tactical strategies to your portfolio is a better investment plan than the undiversified 60/40 model.
I see a choppy and challenging market environment for some years to come as we work our way towards “a better secular destination”, quoting PIMCO’s El-Erian. A nice way of saying, it’s not so good right now.
Why on earth did record amounts of money flow into equities last week? I remember the record money flows into equities in March of 2000 and September 2007. Those periods were followed by significant pain.
Note the three bold red arrows in the following chart (March 2000, September 2007 and January 2013). They reflect record fund flows to equities. Look at the declines post those record periods.
In order to invest successfully, I believe one has to do exactly the opposite of what their emotions are telling them to do. “Sell when everyone else is buying” and “buy when everyone else is selling”. Remember how your clients were feeling in November 2008, February 2009 and October of 2000? Were they not the better times to buy? They were, though it would have been nearly impossible to convince them to get back into the market.
A Who’s Who of Awful Times to Invest
John Hussman, Ph.D. is one of the smartest risk managers I know. He has a process for quantifying risk and hedges accordingly. His process looks at the following: Shiller P/E, the S&P 500 more than 50% above its 4-year low and 8% above its 52-week EMA, investment sentiment as measured by Investors Intelligence, and Treasury bond yields higher or lower than where they were six months ago.
With a Shiller P/E over 18, the S&P 500 is more than 50% above its 4-year low and 8% above its 52-week EMA, individual investor’s bullishness over 47% with bears below 27%, and Treasury bond yields higher than six months ago, the market is “overvalued, overbought, overbullish, with rising yields”. He calls today a “Who’s who of awful times to invest”. Source: www.hussmanfunds.com January 13, 2013 Declaring Victory at Halftime.
Following lists the few times in history when his model measured such extreme caution:
- December 1972 – January 1973: followed by a 48% decline over the next 21 months.
- August – September 1987: followed by a 34% plunge over the following three months.
- July 1998: followed by an 18% loss over the following three months and the beginning of a nearly 14-year period where the S&P 500, including dividends, underperformed Treasury bills, with the S&P 500 nearly 30% lower four years later.
- July 1999: followed by a 12% loss over the next three months and the S&P 500 over 40% lower three years later.
- January 2000: followed by -10% in six weeks and down over 45% by late 2002.
- July 2007: followed by a 57% crash over the following 21 months.
- January 2010: followed by a 7% loss over four weeks, a brief rally and another 11% decline by July 2010.
- April 2010: followed by a 17% market loss over the following three months.
- December 2010: QE2 fueled an additional 10% rally followed by an 18% plunge.
- March 2012: followed by further advance of about 3% over three weeks then a decline of 10% into the fall.
Raise CASH today or at the very least “HEDGE” your long equity exposure. Not because of Hussman’s data, though noteworthy, but because investor sentiment has again reached the targeted Extreme Optimism zone and this combined with an economic backdrop of unmanageable debt, unmanageable entitlement programs, irresponsible deficit spending and global central banks gone mad with currency creation, the backdrop to me spells big risk.
If valuations were lower, dividend yields higher and interest rates higher, I would see less need for active risk management of your long-term equity exposure. That is just not the case today.
Again, please know my intent is not to go to a place of fear; it is to go to a place of awareness on the important role that emotional behavior plays in the investment process. In the simplest form, I believe it is best to be a buyer of equities when everyone else is selling and a seller when everyone else is buying and is the genesis of this weekly piece.
This doesn’t happen frequently and I believe it is easy to monitor and relatively easy and inexpensive to implement. Risk management is important especially at points of optimistic extreme. We have once again reached a point of Extreme Optimism. Hedge long equity exposure and raise cash. Following are the most recent sentiment charts:
Investment Sentiment charts 1-16-13:
Chart 1. NDR Daily Trading Sentiment Composite. I now favor RISK OFF (hedge).
Chart 2. NDR Crowd Sentiment Poll – moved into the Extreme Optimism zone this week. Further advance this week and into next will move Sentiment higher. This chart too favors RISK OFF.
Active hedging strategy
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.
A note on the current cyclical trend
While I comment on risk management tied to investor sentiment extremes, I want to note that the current cyclical bullish trend remains intact. This within the framework of what I believe is a long-term secular bear market trend.
I favor the next chart to identify the shorter-term cyclical bull/bear trends. The chart looks at the 13 week EMA compared to the 34 week EMA. A trend change occurs when the 13 week moves above or below the 34 week. Today, the short-term cyclical trend remains bullish (red circle). I’ll be watching this chart closely in 2013 and will turn even more cautious on long equity should the S&P 500 drop below 1400.
Tactical Investments and other Trading – Alternative Strategies (important note)
Please note: Within your portfolio construction process, I do not recommend hedges against your tactical strategy allocations as they already offer a diversifying return stream to your overall portfolio. There is no need as the strategy should be considered within the framework of your total portfolio for its return and non-correlating risk benefits. If a manager has a process with edge and a proven history to execute his trading process, then ask yourself if the strategy can make money in both up and down trending markets and monitor accordingly. Make sure the manager is sticking to his process. I believe that transparency and liquidity are mandatory. Of course, past performance cannot predict or guarantee future performance.
With warm regards,
Steve
Stephen B. Blumenthal
Founder & CEO
CMG Capital Management Group, Inc.
1000 Continental Drive, Suite 570
King of Prussia, PA 19406
steve@cmgwealth.com
610-989-9090 Phone
610-989-9092 Fax
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