S&P 500 Index 1885
By Steve Blumenthal
April 2, 2014
If you have yet to put some form of portfolio protection in place, I believe it wise to have it in place by month end. I’m referring specifically to your long-term equity portfolio exposure (your stocks for the long run). I do not believe it necessary to hedge your tactical or alternative allocations as they should have risk management processes built in.
I believe most investors are ill-prepared for the end of QE. Valuations are high, margin debt is at a record high and sentiment reflects a far too optimistic investor mindset. Complacency comes to mind.
We are fives years into the Fed’s unprecedented near zero interest rate policy, their experimental currency creation and historic bond market participation (manipulation).
Timing, of course, is difficult as the Fed can continue to invent; however, they are clearly preparing the market for a change in their behavior. There is a limit to all things. It is time to prepare as the risk of a major event looms large.
Seasonal trends point to a May to October correction. A 5% to 20% correction would not surprise me. I believe something far bigger remains a bit farther down the road.
The end of QE is no small event (see here for the Likely Path to Higher Interest Rates). Neither the stock nor the bond markets do well in an up interest rate environment. My best guess is that the serious fireworks begin in mid-to-late 2015 (tied to an aggressive Fed exit).
As famed hedge fund manager, Mr. Klarman, recently wrote in a private letter to clients:
- “When the markets reverse, everything investors thought they knew will be turned upside down and inside out. ‘Buy the dips’ will be replaced with ‘what was I thinking?’ Anyone who is poorly positioned and ill-prepared will find there’s a long way to fall. Few, if any, will escape unscathed.
It is for this reason that I like a new 60/40. Call it 30/30/40. 30% Equities (smartly hedged), 30% Fixed Income (flexible bond funds/strategies), 40% Tactical (broad asset allocation flexibility – relative strength, trend following, sector rotation, risk managed strategies, etc.).
Included in this week’s update (the usual weekly charts):
- Sentiment Charts – Crowd Sentiment is Neutral: Hedge
- Sentiment Indicator Based on Forecasts Gathered From 130 Stock Market Newsletters
- Margin Debt – Record High
- Cyclical Equity Market Trend Charts: Bullish Market Trend Environment Remains
- Cyclical Bond Market Trend Charts: 10-year Treasury & 30-year Treasury: Rising Interest Rate Environment Remains
Investment Sentiment charts 4-1-2014:
Sentiment Chart 1 – NDR Crowd Sentiment Poll: Neutral
Investor sentiment is neutral on both the weekly Crowd Sentiment Poll chart and the Daily Trading Sentiment Composite. The shorter Daily Trading Sentiment Composite did get to extreme pessimism on 3/26/14 and that is a short-term positive; the two sentiment charts that give me the most caution are the Crowd Sentiment Poll (my favorite) and the Investors Intelligence Survey of Advisory Services. In Chart 3 below you’ll see that the sentiment of 130 investment newsletter writers just peaked at the most optimistic level since 1987.
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 – Neutral
Sentiment Chart 3 – Sentiment Indicator Based on Forecasts Gathered From 130 Stock Market Newsletters
The following Investors Intelligence Survey of Advisory Services shows we are experiencing the most optimism since 1987 (NOT A TYPO).
The chart is centered on the concept that the stock market tends to be a manifestation of group psychology in motion, as highs coincide with extreme group enthusiasm and lows coincide with excessive crowd fear. This sentiment indicator uses forecasts gathered from 130 stock market newsletters. Such information can be useful at opinion extremes, because at those extremes the stock market majority is usually wrong. Almost by definition, a top in the market is the point of maximum optimism and a bottom is the point of maximum pessimism.
This is concerning from an extreme sentiment standpoint; however, I will really get concerned when either of the following cyclical trend charts turns bearish. For now, the major cyclical trend for equities remains higher and I continue to lean in that direction.
Following are two of my favorite cyclical market trend charts:
Margin Debt – Record High
Cyclical Equity Market Trend Charts – Both Trend Charts Remain Supportive of Current Bullish Trend
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 trend indicator has historically captured the cyclical bull and bear market trends. Signals occur when the lines cross.
Cyclical Trend Chart 2 – The Big Mo Multi-Cap Tape Composite continues to signal a bullish uptrend for the market. The last “B” buy signal was in 2011. Note the 88% Profitable Long Trades and the Gain/Annum when “Bullish” investing in the S&P 500 Index and the “Switch” to cash on Bearish readings. While no process is perfect, this is a chart to keep your eye on.
Following is a quick look at the trend in interest rates.
Cyclical Bond Market Trend Charts: 10-year Treasury & 30-year Treasury: Rising Interest Rate Environment Remains
The 13 week EMA (blue) line remains above the 34 week EMA (red) line. The 10-year Treasury Bond remains in an uptrending interest rate environment (chart above).
Note the potential change in trend as the 13 week EMA (blue) line is about to cross below the 34 week EMA (red) line. It looks like there is good support around 3.60%. I’ll post this chart again next week.
Conclusion
Put hedges in place by month end. A pretty strong statement from me – I know. I simply believe the cost of such portfolio insurance is smart and worth the expense. While the cyclical bull market trend for stocks remains in place, as highlighted above, risk is high and we are about to enter the seasonally less friendly May to October period. Expect a correction.
Sentiment may serve as a guide in determining when to put some form of risk protection in place. Big Mo has a good track record and helps me position my trading – simply when to get very defensive and when to be more aggressive. I believe that buying out of the money put options is an inexpensive way to protect long-term focused equity exposure. Writing covered calls is additionally smart.
If the operational and logistical challenges are too great to implement some form of equity risk protection, find long-term equity focused funds that have a built in risk management hedging process. There are funds and strategies that incorporate various forms of risk protection. Feel free to reach out to us – we have some good ideas.
CMG Tactical Strategy Update
We continue to hold mostly long equity exposure in our CMG Opportunistic All Asset Strategies. Our CMG Tactical Rotation Strategy moved to a more defensive position for April: 50% TLT (iShares Treasury Bonds) and VNQ (Vanguard REIT). Both strategies are relative strength based trading strategies.
High yield bond prices appear to have bottomed and are moving higher. We traded back into high yield bonds in our CMG Managed HY Bond Program yesterday. April is one of the best performing months for the high yield bond market. We hope this month proves true to form.
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
Provided are several links to learn more about the use of options:
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. We do not offer options strategies at CMG.
Several other links:
http://www.theoptionsguide.com/the-collar-strategy.aspx
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