Storm Clouds Gathering

Posted On January 3, 2019 By Scott Stratton, CFP(R), CFA In Portfolio Management /  

Being an investor requires the humility to acknowledge that no one has a crystal ball and we cannot control the future. I find it best to ignore predictions and forecasts and to tune out day to day news, especially from “experts”. It’s just noise that distracts us from our process. There are always Bulls and Bears, so we run the risk of Confirmation Bias, embracing evidence that conforms to our beliefs and disregarding arguments that differ.

The current Bull Market is nine years old and there have been ample reasons for several years to think that we are in the late innings of this expansion. But anyone who has tried to time the market over the past decade has almost certainly hurt their returns rather than enhanced them.
Over the past two weeks, we’ve observed two significant economic signals which like the proverbial “canary in the coal mine” have been strong predictors of past Bear Markets. Because of their rarity and historical significance, I think investors should consider these signals with more weight than opinions, forecasts, or projections.

1. The crossover of the Equity Circuit Breaker. We’ve described this technical analysis previously, but here is a quick review: We look at the S&P 500 Index and calculate Moving Averages based on the previous closing prices of the past 60 and 120 days. That is each day, we look back at the previous 60 and 120 days. When the market is in an uptrend, the 60 day moving average stays above the 120 day average and both lines are sloping upwards. 

In a Bear Market, a prolonged downturn, the 60 day moving average is below the 120 day average and both are sloping down. The signal occurs when these two lines crossover; this reflects a potential change in regime from an up market to a down market. Because we are looking at longer averages – 60 and 120 days – this analysis usually tunes out brief market panics of a month or two. A crossover occurred this year at the end of November.  

This crossover was a good predictor in past Bear Markets; it would have gotten you out of stocks very early in the 2008 crash and back into stocks in the Fall of 2009. However, it can give false positives. Back in 2016, we also had a crossover occur for several months. That year, if you had traded on the crossovers, you would have gotten out at a loss and then had to buy back into stocks several percentage points higher.

2. Yield Curve Inversion. Typically, longer-dated bonds pay higher interest rates than shorter bonds. This week, however, we briefly saw the five-year Treasury Bond trade at a lower yield than the two-year Treasury, an inversion of the normal upwards slope of the yield curve. 

Why should you care? A Yield Curve Inversion has been a good predictor of previous recessions. This shows that investors are bidding up five-year bonds, preferring to tie up their money for longer, seeing a lack of short-term opportunities elsewhere. It also reflects a belief that interest rates may fall.

Past Yield Curve Inversions have occurred in 1978, 1988, 1998, 2000, 2005-2006. In each case, except for 1998, a recession took place within a year or two. So it does not have a 100% track record of accuracy either, but it is a rare enough of an event that I think it is worth our very careful consideration. The seven previous recessions all were preceded by a yield curve inversion.

Read More: from Bloomberg, “The US Yield Curve Just Inverted. That’s Huge.”

Over the past several years, when people asked me what it would take for me to become concerned about a Bear Market, I would have told them these two things: a crossover of the moving averages and a yield curve inversion. Both have been good (but not perfect) predictors of past Bear Markets and Recessions. And both have occurred since Thanksgiving this year.

The market may continue to go up in 2019, so I cannot assume anything with certainty. Still, I am concerned enough about these two signals that we are going to be slightly reducing our equity exposure and risk levels for our 2019 models. This is a temporary, tactical move and we will look to move back to our target equity weighting either when we feel that prices are significantly distressed, or after the moving averages have crossed back upwards. We are not going 100% to cash; at this point, we are considering reducing equities by 20%, pending further analysis this week.

We will be making necessary trades on a household by household basis before January 1, making sure we minimize any possible tax liabilities. We will look to harvest losses in taxable accounts and to try to avoid creating gains except in IRAs. 

While there’s no guarantee these trades will be profitable, I take these two signals seriously enough that I feel compelled to act and will be doing the same trades in my own portfolio. If we do have a prolonged Bear Market, we may wish to have sold even more. However, I want to balance that risk with the fact that these signals could be wrong this time. Perhaps the market continues up for another year or two before there is a recession and we miss out on significant further gains.  

Investors were not at all successful at timing the market back in 2007-2009, even though with the gift of hindsight, we might think it will be “easy” to see and act next time around. My goal remains to create effective, diversified portfolios that are logical, low cost, and tax-efficient. Making tactical adjustments to reduce risk and hopefully enhance returns is what clients expect from me, but we do not make these changes lightly. If you have questions about your portfolio, or want to talk in more detail about these signals, or the economy, I am always happy to have a conversation about what we can do for you.

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When To Get Out Of Equities

Posted On March 24, 2018 By Scott Stratton, CFP(R), CFA In Portfolio Management /   2 Comments

Look at each time the S&P 500 Index fell by 8% since 1928, and you will find two very different types of outcomes. 85% of the time, an 8% drop resulted in only a shallow correction, an average of 13%, which the market recovered from, on average, in just 106 days. That’s tolerable.

However, in 15% of the 8% drops, the stock market was headed into a severe Bear Market, suffering an average decline of 43%, which took 1090 days to recover.* That’s three years – from the bottom – just to get back to even. Anyone who invested through the Tech Bubble in 2000-2001 and the Crash of 2008-2009 needs no reminder that Bear markets have always been a part of investing.

Given a choice, wouldn’t you rather be on the sidelines when things are falling apart? Investors of all ages feel this way, but for those who are closer to retirement, we don’t have the luxury of saying, “Well, I can just Dollar Cost Average since I don’t need to touch this money for 30 years”.

Most sources say you cannot time the market. That’s because people usually base their decisions on sentiment and worthless forecasts. We are blind to our own confirmation bias, where we look for opinions that support our prejudices, rather than looking objectively at all evidence.

Without a crystal ball, how can you tell when a small drop is just a brief correction versus the first weeks of a longer Bear Market?

To remove human emotion and look solely at the price movement of the market is the objective of Technical Analysis. Let’s consider a chart of the historical prices of the S&P 500 Index. One of the ways to examine the larger trend of market is through a Moving Average (MA). This is simply a measure of the average price over a number of days, such as 20, 60, 120, or 200 days. A Moving Average with small number of days responds quickly to changes in market prices, whereas a MA based on a large number of days is smoother and slower to react.

When the market is boldly moving up (like in 2017), a chart will have these characteristics:

  • The 60-day moving average is above the 120-day moving average, and both have an upwards slope, gaining each day.
  • The current price of the market is above the moving averages, pulling the averages higher.

When we are in a prolonged decline (like in 2008), a chart will typically have the reverse characteristics:

  • The 60-day moving average is below the 120-day moving average, and both have a downwards slope, sinking each day.
  • The current price of the market is below the moving averages, pulling the averages lower.

A brief drop, like we experienced in February, is a temporary blip in the market price and has little impact on the longer 60 or 120 day moving averages. Technical Analysis suggests that a Bear Market may be starting when there is a crossover – when the 60-day MA goes from being above the 120-day MA to being below it.

Crossovers are considered a major shift in the direction of the market, and often do not occur for years at a time. Crossovers occurred relatively early in the previous two Bear Markets and if you had used that signal to sell, you would have significantly reduced your losses. The reverse crossover, when the 60-day breaks above the 120-day MA, is considered a Bullish indicator that the downwards trend has broken. That’s the Buy signal to get back into the market.

A few caveats are in order: these signals will not pinpoint the top or bottom of the market. With a 60-day lag, the market could have already have suffered significant losses before we get a “Sell” signal. Similarly, at the bottom, the market could have rebounded by a substantial percentage before we get the “Buy” signal to get back in. In a shorter Bear Market, these indicators might have you get out at a loss and then buy back in at a higher level, adding insult to injury.

Looking at back-tested funds which use this approach, however, they would have had lower losses in the past two Bear Markets. While it’s nice to avoid the losses, what is even more compelling is how well the strategy performs over 10 or more years. After studying this for nearly two years, we are now going to offer this strategy to our clients, calling it the Equity Circuit Breaker.

This does not change what we purchase in our portfolios. Investors will have the choice of adding the Equity Circuit Breaker or not. If you want to participate, we will track these moving averages and when a crossover occurs, we will sell your equity positions and move the proceeds into cash or short-term Treasuries. When the Bullish crossover occurs, we will buy back into your equity funds, returning to your target asset allocation.

The goal is to reduce losses then next time we have a Bear Market. While there is no guarantee this program will work exactly as it has in the past, you might prefer to have a defensive strategy in place versus the alternative of staying invested for the whole ride down and back up.

I am making this optional for two reasons. First, some investors have a long enough time frame to accept market volatility and prefer a simpler approach. Second, taxes. Selling your equity positions in a taxable account could generate capital gains.

But let’s take a closer look at the tax question. Let’s say you have a 50% gain in your equity positions. You started at $200,000 and it has grown to $300,000. If we were to sell those positions and create $100,000 in long-term capital gains, you’d be looking at 15% tax, or $15,000. (Long-Term Capital Gains could be as high as 23.8% for those in the top tax bracket.) That is a substantial amount of tax, but could still be worth it. If we avoid a 20% drop, you would have prevented $60,000 of losses.

Paying some taxes along the way also will increase your cost basis and basically just pre-pay taxes you would otherwise pay later. For example, Investor A buys a fund for $10,000, sells it at $15,000 after year two and generates a $5,000 capital gain. Then she buys back into the fund with the $15,000 and sells it at $18,000 at year five, for a $3,000 gain. Investor B buys a fund for $10,000, holds it for the same five years, and then sells for $18,000. Both investors will pay the same tax on $8,000 in capital gains. Investor A just split that tax into two segments whereas Investor B paid the tax all at the end.

Of course, if your accounts are IRAs, we could trade without any tax consequences. If you’d like to add the Equity Circuit Breaker to your Good Life Wealth Management Portfolio, there is no additional cost, just reply to this email. We also offer the option of limiting the Equity Circuit Breaker to your IRAs and not to your taxable accounts. I’ll be talking with clients individually throughout the Spring about the new program.

As of today, we have not had a crossover, so there is not yet a trigger for us to sell. I will be looking at this on a regular basis. Investors should make the decision about participating well in advance of the trigger occurring. Once the losses have already started, it is harder to make a decision. I think the best use of this approach is passive – to consider it carefully in advance, turn it on (or not), and then leave it alone. We will do the work for you.

If today’s market is making you nervous, the Equity Circuit Breaker may help you sleep better at night. You have been telling us “we want to participate in the upside, but want to step aside when things get ugly.” If that’s what you’ve been thinking, feeling, or wishing, we can provide you with a plan that’s based on a disciplined process.

*Market Pulse, Goldman Sachs Asset Management, February 2018

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