S&P 500 Index 1656
By Steve Blumenthal
July 10, 2013
Investor Sentiment continues to support the bullish market view (Extreme Pessimism was touched last week and I became more constructive with the S&P 500 at 1609). I remain modestly bullish from a trading and risk management perspective. Look to re-establish hedges when Investor Sentiment again becomes Extremely Optimistic.
However, keep in mind that forward 7 and 10-year expected return outlook for equities remains exceptionally low to negative (see GMO and Research Affiliates charts below).
Given this, I believe both the equity and fixed income markets remain in a period of time that favors active risk management (hedging) on long equity exposure, inflation protection on fixed income exposure, and the inclusion of tactical and other important portfolio risk diversifiers. Everything is a risk. The magic is in combining and managing various risks together into one portfolio.
Along with a proactive approach to equity risk management, as discussed regularly in this piece, it is equally important to have meaningful exposure to tactical investment strategies and other forms of “highly liquid” alternatives. These are strategies that have the ability to tactically shift from fixed income to equities, or trade the up and down trends in the markets, or uniquely trade currencies (and more…). The good news is that there are solid strategies available to you and all of your clients (not just the pensions, endowments and super affluent). The hard part is finding them.
Look for experienced managers who have the ability to produce a return stream that does not correlate to the equity and fixed income markets as well as being non-correlated to your other tactical managers. Think “Enhanced MPT”. The period ahead requires broader diversification. Given today’s low dividend yields, low inflation and low interest rates, the traditional 60/40 mix is in trouble. Broaden your portfolios.
Following are the most recent Investor Sentiment charts, two charts reflecting the current cyclical bullish trend (watch these), GMO’s most recent 7-year forward projected return chart, Research Affiliates 10-year forward return chart updated by CMG and an interesting cyclical bull/bear chart on gold:
Investment Sentiment charts 7-9-2013:
Sentiment Chart 1. NDR Crowd Sentiment Poll – Neutral from Below (“Risk On” at S&P 500 Index level 1609)
Investor Sentiment has moved into the neutral zone from below 57. I favor removing hedges at points of Extreme Pessimism. This happened just prior to the July 3, 2013 Trade Signal. The cyclical bullish trend remains in place as reflected on the next two charts.
Sentiment Chart 2. NDR Daily Trading Sentiment Composite – Extreme Pessimism (Bullish)
This daily sentiment chart also supports a move higher in equities.
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 the buy and sell signals:
GMO’s 7-Year forward expected return chart
Research Affiliates’ 10-year forward expected return chart
Note the correlation to expected and actual return – CMG chart using RA data
GOLD Cyclical Trend Chart:
In this next chart, I apply the same 13/34-week EMA lines to GLD that I did to the S&P and have divided the cyclical bull and bear market trends, as noted by the blue and red vertical lines (blue line marks the beginning of the cyclical bull trend and red line marks the beginning of the cyclical bear trend). Currently we are in a cyclical bear trend move.
My personal view on gold is that it is an important diversifier within a portfolio (call it 5% to 10% and rebalance periodically). I view it as a currency more than a commodity and feel that the global currency experiment (and related currency wars) will lead to some form of a gold-backed currency. One way to time exposure might be the 13/34-week EMA. It has done a pretty good job at catching the trends. Personally, I like gold today as I see solid support at 114. What is interesting to me is that 113.44 represents a 50% retracement of the 2005 low to 2011 high. The next line of support is 100.44 (for the Fibonacci fans, note that the 61.8% retracement is at 96.35).
In summary
The U.S equity market remains in a cyclical bull market up trend. I strongly believe we are in a period of time that favors proactive risk management (hedging your long equity exposure). Over time I have found that establishing and removing risk protection based on investor sentiment extremes has served me well. Of course, there is no fool proof way to invest in anything. The idea is to have a risk focused plan.
Extreme Pessimism was reached just prior to the July 3, 2013 Trade Signals at the same time the technical support level between 1560-1580 held. This is a short-term positive which favors the continuation of the current cyclical bull market move.
Risk remains elevated as forward expected returns are low. Buying very deep out of the money put options is an inexpensive way to hold continued equity risk protection. For now, I favor risk on.
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.
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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