S&P 500 Index 1780
By Steve Blumenthal
December 18, 2013
The cyclical trend remains positive (though aged) and we are entering a seasonally friendly time of year for the equity markets. This week, along with the usual sentiment and cyclical trend charts, I include an interesting chart showing the history of market performance from mid-December into January (aptly named Santa Claus rally).
The study shows that 41% of the markets’ annual return comes from the period between December 22 and January 6. Of course, past performance guarantees you and me nothing.
Included in this week’s update:
- Sentiment Charts – Extreme Optimism: Protect/Hedge Long Equity Portfolio Exposure
- Cyclical Bull or Cyclical Bear Market Trend Charts – Both Trend Charts Remain Bullish
- The Santa Claus Rally – A Great Chart
- My Two Cents – Big Picture Market View
Investment Sentiment charts 12-17-2013:
Sentiment Chart 1 – NDR Crowd Sentiment Poll – Extreme Optimism: Protect/Hedge Long Equity Portfolio Exposure
At a current reading of 67.3 (see yellow circle), investor sentiment remains in the Extreme Optimism zone. Note the market movement at past peak readings (yellow arrow). A correction remains highly probable.
If you are a new reader, the gray area highlights the historical market performance when Investor Sentiment, as measured by Ned Davis Research, moves into the Extreme Optimism (Bearish) zone (above the dotted black line or a reading of 66).
Sentiment Chart 2 – NDR Daily Trading Sentiment Composite – Getting better here – note it is nearing the neutral zone; however, still Extreme Optimism
Cyclical Bull or Cyclical Bear Market Trend Charts – Both Trend Charts Remain Bullish
Cyclical Trend Chart 1 – 13/34-Week EMA – The cyclical bull market’s uptrend remains in place. Note the blue 13-week EMA line remains above the red 34-week EMA line. Also note how well this simple, tactical indicator has historically captured the cyclical bull and bear market trends. Signals occur when the lines cross.
Cyclical Trend Chart 2 – Big Mo continues to signal a bullish uptrend for the market. Note the 84.6% Profitable Long Trades and the Gain/Annum when “Bullish” investing in the S&P 500 Index and “Switch” to cash on Bearish readings. While no process is perfect, this is a chart I have favored for many years. Keep an eye on this chart.
The Santa Claus Rally – a hat tip thanks to my friends at 361 Capital
We’re getting close to what is historically the best time of the year for stocks.
From Ed Elfenbein at Crossing Wall Street:
I took all of the historical data for the Dow Jones from 1896 through 2010 and found that the streak from December 22nd to January 6th is the best time of the year for stocks. (December 21st and January 7th have also been positive days for the market but only by a tiny bit.)
Over the 16-day run from December 22nd to January 6th, the Dow has gained an average of 3.23%. That’s 41% of the Dow’s average annual gain of 7.87% occurring over less than 5% of the year. (It’s really even less than 5% since the market is always closed on December 25th and January 1st. The Santa Claus Stretch has made up just 3.8% of all trading days.)
Here’s a look at the Dow’s average performance in December and January (December 21st is based at 100): (CrossingWallStreet)
My Two Cents – Big Picture Market View:
I’m expecting a meaningful correction in 2014.
The cyclical bull market trend remains positive. It is important to stay with that trend; however, downside risk can be managed by following a disciplined approach.
Since investor sentiment is once again in the Extreme Optimism zone, now is a good time to risk protect. I favor a collared option strategy initiated when investor sentiment is extremely optimistic and removed when it is extremely pessimistic.
Trade Signals is designed to help you navigate the risks and rewards of the stock market. I believe a less certain investment outlook is ahead due to unmanageable debt, entitlements and unprecedented central bank manipulation. We are in a debt deleveraging cycle. Such cycles are different than re-leveraging cycles. What is required today is some form of risk mitigation. Fortunately, there are relatively inexpensive ways to protect your important long-term equity exposure.
Some form of an active approach to risk management is prudent. If hedges are now in place, look to remove them when Investor Sentiment moves back into the Extreme Pessimism zone (I favor the NDR Crowd Sentiment Poll…I’ve relied on it for years; however, others favor the Daily Sentiment Poll. Both charts are useful).
The backdrop of low dividend yields, low inflation and low interest rates points to a low forward 10-year expected return. That means risk is higher today. Further, the macro fundamental picture remains challenged due to unmanageable levels of debt, unmanageable entitlements and unprecedented market manipulation from the world’s global central banks. It is not normal to have markets so manipulated.
We are in uncharted waters. Stay vigilant and construct portfolios that are broadly allocated to a diverse set of risks.
All the very best!
With kind regards,
Steve
Stephen B. Blumenthal
Founder & CEO
CMG Capital Management Group, Inc.
Philadelphia – King of Prussia, PA
steve@cmgwealth.com
610-989-9090 Phone
For hedging, I favor a collared option approach (writing out of the money covered calls and buying out of the money put options) as a relatively inexpensive way to risk protect your long-term focused equity portfolio exposure. Also, consider buying deep out of the money put options for risk protection.
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. Go to www.CBOE.com to learn more. Hire an experienced advisor to help you. Never write naked option positions.
Additional information and disclosures: 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. You might also consider spending just 1% per year of your total equity exposure on buying deep out of the money put options. The purpose of Trade Signals is to begin a dialog around a disciplined risk management approach on core equity portfolio exposure.
33/33/34 – My broader view is outlined in a piece called The Portfolio Construction Game Plan for 2013. And subsequent posts at www.cmgwealth.com.
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.
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. 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.
IMPORTANT DISCLOSURE INFORMATION
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk. Therefore, it should not be assumed that future performance of any specific investment or investment strategy (including the investments and/or investment strategies recommended and/or undertaken by CMG Capital Management Group, Inc (or any of its related entities-together “CMG”) will be profitable, equal any historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. No portion of the content should be construed as an offer or solicitation for the purchase or sale of any security. References to specific securities, investment programs or funds are for illustrative purposes only and are not intended to be, and should not be interpreted as recommendations to purchase or sell such securities.
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