S&P 500 Index 1687
By Steve Blumenthal
August 7, 2013
Following are the most recent Investor Sentiment and Cyclical Trend charts. Investor Sentiment remains in the Extreme Optimism or “Bearish” zone.
As a quick aside, years ago I was the elected Chairman of a non-profit industry organization called NAAIM (National Association of Active Investment Managers). NAAIM is a great group of people focused on technical analysis and tactical trading.
One of the interesting things I have observed over my 30 years in the business is how professional managers are prone to the very same emotional tendencies that drive poor individual investor decision making. This was evident in my early years spent at Merrill Lynch and remains equally evident today.
Each week I look at several investment sentiment charts. The NDR Crowd Sentiment is a broad look at individual investor sentiment and combines some professional investor sentiment as well. The NAAIM sentiment chart singularly looks at the investment sentiment of the NAAIM members (all pros). The Daily Sentiment looks at a broad array of investors and NDR updates the changes each day. Of course, you can find many other sentiment surveys that do the same.
I like taking the pulse on overall market sentiment but over the years have come to zero in on NDR’s Crowd Sentiment Poll as my favorite. One can get a bit off-center by looking at too many charts and indicators. Zero in on something that has served you well and stay focused.
Across the board today, Investor Sentiment is excessively bullish. I can hear the great Sir John Templeton whispering in my head again, “buy when everyone else is selling and sell when everyone else if buying”. However, the Cyclical Bull Trend remains solidly in place. My point is that risk, given today’s significant issues, should be proactively managed. Sentiment, at points of extreme, can serve as a helpful guide.
Also included in today’s piece is my favorite valuation chart (as measured by “Medium PE”). Interesting to note is that the chart shows the market currently overvalued by about 17% and reflects an extreme overvaluation target of 1850 on the S&P 500 Index. This chart shows that prices in the store are marked up today. It’s better to wait to get aggressive when they go on sale (have patience – don’t chase in today).
Finally, if you are curious about where individual investors are putting their money, be curious no more. I include a great chart with data from the American Association of Individual Investors.
Following is this week’s post:
Investment Sentiment charts 8-6-2013:
Sentiment Chart 1. NDR Crowd Sentiment Poll – Extreme Optimism (Bearish) -hedge core equity exposure.
Sentiment Chart 2. NDR Daily Trading Sentiment Composite – Extreme Optimism (Bearish)
Sentiment Chart 3. NAAIM Survey: Here too… Extreme Optimism (Bearish)
Just for fun, this week I thought I’d add the NAAIM chart.
Each week the NAAIM organization polls its members to see if they are bullish or bearish on the market. Note how successful the buy signals are when “Below 14%” of polled members are bullish (blue circle and line). This is a great contrarian indicator. Current reading is in red.
Both the 13/34-Week EMA and Big Mo Cyclical Trend Charts Remain Bullish
Cyclical Trend Chart 1: 13/34-Week EMA – remains bullish as the 13-week line remains above 34-week
Cyclical Trend Chart 2: Big Mo Cyclical Trend – remain bullish
Medium PE chart: Fair Value at 1400, Upside at 1850, Downside at 1000
There is a lot of argument around PE as a valuation metric. I favor NDR’s Medium PE, which essentially looks at the medium reported earnings (based on actual earnings over the prior 12 months) from the 500 companies that make up the S&P 500 Index (think eliminating the high and low PEs and going with the medium average).
For 49.4 years, the Median PE equals 16.7. If that is the baseline for a fair evaluation, the current Median Fair Value of the S&P 500 Index is 1394.34 as of 7/31/13.
A one standard deviation move to the upside puts the market in an overvalued position at 1827.84 (about 8% higher than today’s level).
A one standard deviation move to the downside puts the market in an undervalued position at 960.81.
A correction within the current cyclical bull market to 1575 (the 2000 and 2007 highs) is probable given the Extreme Bullish Investor Sentiment. The upside target is 1827.84.
American Association of Individual Investors Allocation Survey
Risk remains elevated as investment sentiment is far too bullish. Therefore, risk protect core equity portfolio exposure via some form of hedge. I favor removing hedges when Investor Sentiment moves back to a point of Extreme Pessimism.
I’m often asked about hedging tactical strategies – I see no reason to hedge and frankly no viable way to hedge that portion of your portfolio’s exposure. Those strategies are non-correlating and serve an important diversification role in your portfolio for a reason. Divide your portfolio into three distinct buckets: Equities, Fixed Income and Tactical-other. Think 33/33/34 vs. 60/40.
There are other risks as we are living in highly unique and interesting times. The intent of this piece is to help shape a disciplined risk management approach as it relates to your core equity holdings.
It is my hope that you find this information helpful. It’s August and the team here is humming beautifully. My 15 year old son just showed up in my office and we are sneaking out early to the golf course.
The Fed-induced Taper Tantrum is one thing; I hope my little guy (ok – and me) avoid all golf-related tantrums. The game can be such great fun but it is often so very humbling. I hope you too are having a great day!
Wishing you 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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