S&P 500 Index 1826
By Steve Blumenthal
February 12, 2014
Last week, short-term investor sentiment as measured by the NDR Daily Sentiment Poll reached the Extremely Pessimistic zone (a Bullish signal) while the NDR Crowd Sentiment Poll (a somewhat slower measure of sentiment) was nearing Extreme Pessimism but remained neutral.
At the core, I believe we remain in an aged, overbought and overvalued cyclical bull market. The backdrop of too much debt, unmanageable entitlements, an unfavorable tax environment and increased regulation are simply not good drivers of forward returns. Risk is high and the market is dependent on the Fed’s currency creation machine and heroic yet unnatural market participation (manipulation). A powerful force – for now. See Breaking Bad – it’s about when bad economic data is good (more juice from the Fed) and when good news is bad (fear of no more love from the Fed).
Trade Signals is a weekly piece that looks at investor sentiment and identifies levels of both extreme optimism and extreme pessimism. Those extremes may provide a path towards a proactive risk management process. I favor establishing put option hedges when crowd sentiment becomes excessively optimistic and removing put option hedges when Crowed Sentiment becomes exceedingly bearish. Given today’s Crowd Sentiment Poll neutral reading, I remain in the hedged camp.
We are living in interesting times to say the least. Options can help you manage risk as can broader portfolio diversification to include other important return drivers. Very shortly we will be releasing our white paper on Understanding Tactical Investment Strategies.
I suggested last week that more aggressive traders may want to remove the hedge. That was the better call; however, this game is a tough game and I stayed in the hedge camp. My personal process favors the slower moving Crowd Sentiment Poll as I have used it for years.
If the equity markets were fairly valued today, I’d suggest there be no need to actively risk protect your equity portfolio exposure. It is just that the market is nearly one standard deviation above fair value at a 21 times Price to Earnings ratio. That’s too expensive for my blood and nearly 400 S&P 500 index points above its 49-year median PE of 16. I believe some form of risk management is prudent and worth the small expense. If I’m wrong, the cost of protection is worth the small cost (like insurance on your home), budget how much you’re willing to spend annually to risk protect your long-term focused equity exposure – and don’t overcommit. There is a lot of downside protection leverage in the put options and you can control and limit your costs.
Ultimately, it is risk management that limits downside loss. This, in turn, enables the power of compound interest to work its magic over time. Overcoming a 50% decline requires a 100% return and takes valuable compounding years away from you. That takes years to recover from. Some may have those years, many may not. Go to www.cboe.com to learn more about options or Google collared option strategy.
As a quick and logical aside: No one wants to sell when everyone else is buying. The reality is that by the time optimism reaches bullish extreme, most of the buyers are in the game. There is less money available to fuel the market higher. The reverse is true when everyone is selling. Panic flushes out the sellers subsequently creating room for the buyers (lacking little pressure from maxed out sellers) to push the market higher. I recommend going against the crowd at points of extreme.
So I remain in a hedged mindset today and while “bad is good”, right now I’m Yell-in for Yellen.
Included in this week’s update:
- Sentiment Charts – Crowd Sentiment is neutral: Hedge
- S&P 500 Correction Targets
- Length of S&P Streaks without a 10% Correction
- Cyclical Equity Market Trend Charts -Both Trend Charts Remain Bullish
- Cyclical Bond Market Trend Charts – Both Trend Charts Remain Bearish
- Don’t Fight the Tape or the Fed – Bullish
Investment Sentiment charts 2-11-2014:
Sentiment Chart 1 – NDR Crowd Sentiment Poll – Neutral Optimism: Better but I still favor hedging long-term focused equity portfolio exposure until Extreme Pessimism is reached.
Investor sentiment most recently peaked at 73.9. This is the second highest reading ever recorded – data 1995 to present. I mentioned a few weeks ago, “To shout caution is an understatement.” I continue to favor hedging long-term equity exposure.
Consider removing hedges and adding to or rebalancing to your targeted equity exposure when pessimism moves to extreme. We may have missed that point for now. Upside for now is preferable to the small cost to hedge.
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 – Now reading Extreme Pessimism. Aggressive traders might consider removing hedges and adding to positions especially given the market support at 1730 (see S&P 500 Correction Targets chart below). Personally, I favor the slower moving NDR Crowd Sentiment Poll.
S&P 500 Correction Targets
Note the bounce since last Wednesday’s post:
- I noted last week that the S&P 500 Index was testing the next level of logical support at 1729.86 today (top of large blue box). That support held and the market has rallied nicely.
- The next challenge will be the retest of the recent market high at 1850.84
- A correction to 1500 in the S&P 500 index represents an approximately 50% retracement of the most recent rally and would mark a more attractive value closer to the 49-year PE ratio of 16.
Length of S&P Streaks without a 10% Correction
If you are wondering how long this cyclical bull has traveled without a 10% correction, here is a great look (add another seven days or so to the green bar):
Source: (BespokeInvest)
While I favor the Crowd Sentiment data, I also look at a few other sentiment charts each week. The following Investors Intelligence Survey of Advisory Services shows the most optimism since 1987 (NOT A TYPO).
As for the major cyclical trend for equities, the trend remains higher. Here are the two charts I watch each week:
Cyclical Equity 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 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. Note the 84.6% 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 I have favored for many years. Keep an eye on Big Mo.
Don’t Fight the Tape or the Fed
Because the cyclical trend is bullish, it is still a buy the dip correction in my view (yet I do think that another major correction aka 2008 lies ahead). My additional two cents is to stay in-line with the primary trend and remain focused on active risk management and broad asset diversification vs. calling tops. It is just so nearly impossible to do.
Cyclical Bond Market Trend Charts – Both Trend Charts Remain Bearish (interest rates are rising)
10-Year Government Bond Chart
The current 10-year Treasury Note yield is 2.752% (red arrow above). For some reason StockCharts shows it as 27.52. That really means 2.752%. The 13-week EMA is the blue line and the 34-week EMA is the red line. Trend change occurs when the lines cross. Rates are in a rising uptrend. This is bearish for bonds. Upside target is 3.30% then 3.75%. Downside target is 2.25%.
30-Year Government Bond Chart
The current 30-year Treasury Bond yield is 3.709% (red arrow). The 13-week EMA is the blue line and the 34-week EMA is the red line. Trend change occurs when the lines cross. Rates are in a rising uptrend. This is bearish for bonds. Upside target is 4.20% then 4.75%. Downside target is 3.40%.
Conclusion
Think in terms of allocating a small annual risk budget (say 1% to 2%) to buy out-of-the money put options and follow a disciplined game plan. The idea is to hedge just your long-term focused core equity positions. If you have 60% allocated to equities with no intention to sell, put options may be a liquid and tradable tool for you to use to hedge. I like a collared option strategy to reduce the cost of the hedge and placing the hedge protection in place when investor optimism is extremely bullish. That’s when put options are the cheapest.
These sorts of sentiment extremes tend to set up just a few times per year. Since I favor (the slower moving Crowd Sentiment Poll) the recommendation to hedge remains in place. We’ll see what next week brings.
Like my dad always used to say, Janet Yellen is, “somewhere between a rock and a hard place”. Let’s see what the next few years bring.
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
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