S&P 500 Index 1798
By Steve Blumenthal
December 4, 2013
Each week I try to add an interesting chart or two. This week, along with the usual sentiment and cyclical trend charts, I have included an additional sentiment chart plotting Investors Intelligence weekly survey of financial advisors and share a tactical approach to trading gold.
You’ll see that the percentage of investment advisors who are bearish (least pessimistic) on the market is at the lowest level since 1987 (not a typo). Fewer investment professionals are bearish than at the market peaks in 2000 and 2007! This is concerning. Too many bulls, too few bears: Expect a correction.
Now, with that said, the major trend remains higher. Thus, I favor a hedged approach and a buy-the-dip mentality as long as the cyclical trend charts (below) remain bullish. I’m looking for investor sentiment to move from extreme optimism back to extreme pessimism to remove hedges and/or buy the dip.
For now, with the cyclical trend remains positive but with valuations relatively high and the cyclical trend aged, my radar is up. Today, bullish sentiment is high and a correction probable. I believe long-term, focused equity portfolio exposure should be hedged. Fortunately, there are a number of inexpensive ways to do so.
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
- How to Tactically Trade Gold – Consider 13/34 Week EMA
- My Two Cents – Big Picture Market View
Investment Sentiment charts 12-3-2013:
Sentiment Chart 1 – NDR Crowd Sentiment Poll – Extreme Optimism: Protect/Hedge Long Equity Portfolio Exposure
At a current reading of 71.3, you can see in the chart that we are way up in the Extreme Optimism zone. This should cause some caution but like other market extremes, caution is pushed to the side when investors feel good. Note the market movement at past peak readings. A correction is 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 in this chart, 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 – Also Showing Extreme Optimism
Sentiment Chart 3 – Investors Intelligence Weekly Advisor Survey
Cyclical Bull or Cyclical Bear Market Trend Charts – Both Trend Charts Remain Bullish
Cyclical Trend Chart 1 – 13/34-Week EMA – 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.
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. Debt deleveraging 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.
How to Tactically Trade Gold – Consider 13/34-Week EMA
I’m often asked about gold. I do believe it is an important portfolio holding (perhaps 5% to 20% depending on your forward view and risk appetite). With that there might be a better way to add and reduce exposure similar to the way you may risk manage your stock market exposure using the 13-week over 34-week exponential moving average (EMA). Like the Cyclical Trend Chart 2 above, buy signals occur when the 13-week EMA (blue line) crosses above the 34-week EMA (red line). Note the timely sell signal earlier this year. I call this a tactical trend following strategy.
An EMA is a type of moving average that is similar to a simple moving average, except that more weight is given to the latest data.
My Two Cents – Big Picture Market View:
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.
My best guess is for a sell off into January with a further rally to follow. This view is based on today’s excessive level of optimism and the charts supporting the current cyclical bull trend. Overall, the cyclical bull trend remains aged and market valuations are relatively overpriced (Median Fair Value at 1445 based on the most recent reported earnings using NDR’s Median PE calculation). However, markets can grow to be more aged and even more overpriced. For now, the cyclical trend remains positive.
A probable upside target is 1893, which represents a one standard deviation move above Median Fair Value. Thus, I see the S&P 500 Index overvalued at approximately 1893. Let’s see what stock ownership and investor sentiment look like at that level. Downside risk is to 997.
Also supporting a continuation of the cyclical uptrend is a strong dollar, foreign investor capital flows into US equities and pensions desperate to earn 8% (money flows from bonds to stocks). In the global race to debase one’s currency, we look just a bit prettier than the others. Thus, we’ll likely benefit from capital inflows and a reposition of pension assets from bonds into equities. Global liquidity crosses boarders quickly and the global central banks are doing all they can to create liquidity.
How much higher? Don’t know. How much longer? Don’t know. I see another major bear market within the next 18 months.
My best guess is a one standard deviation move above fair value is as good a short-term upside target as any but it could be two standard deviations above – though I think that is far less likely (see above median valuation chart).
I am carefully watching for a change in trend. I favor the two cyclical trend charts reflected above and will recommend a far more conservative posture towards equities when the 13/34-week EMA chart or Big Mo indicate a shift from a Cyclical Bull uptrend to Cyclical Bear downtrend.
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.
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