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The graph above is one that I follow fairly closely (and have for years) to give me a feel for the direction of the stock market as represented by the S&P 500 Index. This is a graph that I last showed you this summer when I explained why we had raised cash in client accounts.
This monthly graph of the S&P 500 shows me the prevailing trend in index and its strength. The indicator in the bottom pane is the Price Momentum Oscillator. This indicator shows us how much momentum is behind the current trend, and the direction the trend is headed.
You can see that I’ve circled a few different points on the oscillator and on the price graph above it. These represent longer term trend changes in the index. You can see that in late 2009, after the crash had bottomed, the indicator turned positive and stayed that way for several years as the market recovered and moved to new highs.
Earlier this year, the indicator turned negative which is one of those flashing red lights for me as a portfolio manager. The market in turn moved sideways for several months while we raised cash in client accounts. In August and September, the market corrected >12%, but during October it moved back toward its old highs.
Unfortunately, the indicator continues to point to a weak stock market with potentially lower prices. I say potentially because no indicator is 100% fool-proof. This one has proven very reliable over the years and allowed us to take action ahead of major downturns and allowed us to get aggressive ahead of major bull market moves.
I’ve written before, but it seems like a good time to repeat it, that all charts are just representations of investor psychology. If I look at this chart along with breadth statistics (like less than 1/2 the companies in the index are trading above their 200-day moving average – or in simple terms – less than 1/2 the companies in the index are in a bull market stage), I think this is telling us that investor psychology is weakening. It may be because most now believe the Federal Reserve will raise interest rates in December or it may be some other less apparent reason – who knows.
As long as this red flag is out there, I plan to be cautious until a clear path to higher prices presents itself. Just as we did with the August/September correction, we will be opportunistic with any sell offs and add to positions; conversely, as we have been doing over the past week or so, when the market moves back toward old highs, we will lock in the gains and raise cash.
Risk management is a key component to investment management and having the right tools in place to effectively execute your strategy maximizes performance. Being conservative when risks are high and aggressive when risks are low are key to beating the indices.
Today’s video has no tie in to the blog post other than I was in the third row of the REO Speedwagon concert last night:
So I thought I’d share one of my favorite songs that was written not too far from where I am sitting writing this post. Enjoy!
I thought a quick update of the things I am seeing in the market would be of interest to everyone. In short, I think we are due for a bit of a pullback based upon how the market internals are reacting to recent events.
Above is a graph of the S&P 500 Index along with several indicators that I follow.
The top panel is the Relative Strength Index. This indicator measures the momentum in the market based upon price change and the speed of those changes. Whenever it shows a reading above the 80 level, this generally means that the index has moved up too fast giving us an overbought situation. Generally, this is corrected by a drop in prices of a few to several percentage points in the index. You can see that I have circled the overbought reading in red.
What I see here is a warning sign that the market could pull back sometime over the next few days to consolidate the gains it has chalked up.
The panel below that is the S&P 500 Index itself. In this case, I am using the candlestick version of the graph because it gives me an idea of what happened on each day based upon the color (black is up, red is down) and size (trading range for the day). You will also notice a light beige color under the index – this is an area graph of the S&P 500 Equal Weight Index, a totally separate measurement of the same 500 companies with the difference being that the S&P 500 Index is weighted based upon the size of the company (Apple is the biggest company in the index by Market Capitalization, so it makes up the largest percentage of the index). The Equal Weight Index simply takes all 500 companies and weights them at 0.2% of the total.
I have drawn two red boxes and two red lines on this graph. The red box on the left shows you the last time that there was a divergence between the two indices, with the Equal Weigh falling in value while the S&P 500 kept moving higher for a few days. You can see that after a few days, the S&P 500 Index fell as well. The box on the right shows you the market action of the past few days. You can see by the two red lines I drew that the S&P 500 continues higher (except for two small down days yesterday and today) when the Equal Weight has already moved lower.
What I see here is a warning sign that the market is ready to pull back similar to the way it did in the red box on the left.
Further down, you see I have a red oval drawn over the Full Stochastics indicator. This is again a momentum indicator showing an overbought reading. This supports the earlier momentum indicator, telling us to expect a bit of a pullback in coming days.
The bottom three indicators are all breadth indicators for the market – basically, they tell us how individual stocks are reacting within the market as a whole.
The uppermost of the bottom three is the Advance / Decline line indicator I use. You see that the blue shorter term 10 day moving average line has been falling the past several days indicating that on a daily basis there are a greater number of companies falling in price. It has just crossed over the red intermediate term 30 day moving average line which is holding steady.
What this tells me is that the intermediate term picture is still healthy, but near term we are in for a price pull back.
The middle of the three panels is the McClellan Oscillator – a breadth measure of the net advances and declines – you can see that it I have drawn a red down trending line. This represents a divergence from the S&P 500 which has continued higher as breadth has weakened. You can see that it is now below zero, telling us that there are now more stocks falling in price than gaining in price. Additionally, you can see the purple arrow I drew showing the days that they indicator was above the 50 level. Historically, readings above 50 cannot be sustained and a drop in both net advances and declines as well as prices is ahead.
What this tells me is that we should see the index fall in price soon.
The bottom of the three panels is the McClellan Summation Index. This is a derivation of a derivation – it basically takes the readings of the McClellan Oscillator and adds them together. That give us an intermediate term indicator, which currently shows that the intermediate term outlook for the market is fine.
In addition, we skipped several panels in the middle of the graph that show us cash flow is still moving into the market and that the intermediate term picture is good as of now.
In recent weeks/months, I’ve discussed the divergence between corporate earnings and stock prices. Corporate earnings are predicted to be down 15% in 2015 (and that forecast is proving correct) whereas the stock market – until the August swoon – was moving ever higher and achieving more unrealistic valuations. A lot of the overvalued situation corrected itself in August, but since end of September, the market has moved back toward the old highs.
I advised you that as we approached the 2050 area of the S&P 500, we would employ risk management and start raising cash for the inevitable pull back in prices to sustainable levels. When the McClellan Oscillator moved over 50, we began to book profits on many of the stocks we bought during the August correction. We have also been sellers of higher beta stocks (ones that are inherently more volatile than the overall market), and we have included sales of some companies whose performance has been weak due to sales or foreign exchange issues so that when the fall occurs, we hold the strongest companies possible so that we outperform the index.
Risk management is a critical part of active portfolio management and we utilize both fundamental analysis and technical market indicators to help us achieve this goal and to keep everyone happy.
One of the questions I receive the most from clients is whether they will run out of money. Will their savings be able to sustain their spending during their retirement years.
No one has a crystal ball, but we use a technique called Monte Carlo Simulation. Monte Carlo portfolio simulation provides a means to test long term expected portfolio growth and portfolio survival during retirement withdrawals, i.e., whether the portfolio can sustain the planned withdrawals during the client’s retirement years.
In the image above, you can see that we use an all equity portfolio that consists of:
45% Large Cap Value Stocks
15% Mid Cap Value Stocks
10% Small Cap Value Stocks
5% Real Estate Stocks
5% Emerging Markets Stocks
10% European Stocks
10% Pacific/Asian Stocks
Our assumptions are that the client will withdraw 5% of the ending market value each year and that inflation will be an average annual 1.5%.
The way the simulation works, the model randomly selects an actual annual historic returns for each investment class above and projects the portfolio balance and distribution amounts over a 30 year period. It then repeats this multiple times (e.g., 1000), aggregates the results, and gives us a statistical probability that the client’s money will last over the 30 year period of time.
In the example above, the client starts with $300,000 invested in the portfolio allocation as detailed. He withdraws his 5% at the end of each year, and the portfolio is then rebalanced to the target asset allocation.
The graph below shows you the possible projected balance and portfolio growth pattern based upon these parameters over the 30 year simulation period, with the yellow line showing how the portfolio growth looks at the 75th percentile, the blue line the median portfolio growth, and the orange line showing the 25th percentile.
The graph below shows you the possible projected distribution dollar amounts based upon these parameters over the 30 year simulation period, with the yellow line showing how the portfolio growth looks at the 75th percentile, the blue line the median portfolio growth, and the orange line showing the 25th percentile.
The results are that in all cases, there is a 100% probability that the client will be able to sustain a 5% withdrawal rate from their portfolio and that the median market value of the portfolio at the end of 30 years will be $1,025,801 and that the median withdrawal in the 30th year will have grown to a bit over $51,290 in today’s dollars.
Most people, however, do not want to have an all equity portfolio in their retirement years. Most want a portfolio that is less volatile and that could sustain a higher distribution amount. The portfolio mix that historically provides the highest return for the least amount of risk is one that is 65% equity and 35% fixed income. Below, we have adjusted the portfolio above to add 35% fixed income to it, diversified across various fixed asset classes.
29.25% Large Cap Value
9.75% Mid Cap Value
6.50% Small Cap Value
3.25% Emerging Markets
6.50% Intl Europe
6.50% Intl Pacific Region
5.00% Long Term Treasuries
10.00% Intermediate Term Treasuries
5.00% Short Term Treasuries
15.00% Corporate Bonds
Additionally, we have increased the distribution amount to 7% of the market value and increased the average annual inflation rate to 3%. Here are those results:
> Median market value of the portfolio at the end of 30 years will be $623,532
> Median withdrawal in the 30th year will have dropped to a bit over $19,763 in today’s dollars due to the impact of inflation and the lower portfolio growth – in other words, even though you are receiving $47,095 in actual dollars, you will have lost significant purchasing power with this blended allocation such that it will be like having $19,763 today
> There is a 100% probability that the client will be able to sustain a 7% withdrawal rate
When you compare the risk of the two portfolios, in the 100% equity portfolio, your largest down year was a loss of -42.46% compared to a loss of -30.26% for the 65/35 portfolio. Your volatility for the 100% equity portfolio is a standard deviation of 9.52% compared to the 65/35 portfolio’s standard deviation of 7.82% – the easy way to think of this concept is to ignore the statistics (standard deviation being a measure of the variability of the portfolio returns over the 30 year period – see, ignoring it is better) and view the 100% equity portfolio as 20% more volatile than the 65/35 portfolio.
We can even push the limit and move the portfolio allocation to 50/50. Your median market value drops to $537,564 but your withdrawals will have dropped to $17,002 in today’s dollars due to the impact of inflation and lower portfolio growth.
Finally, lets look at a 100% fixed income portfolio. Those are some ugly results. If we have an expected return of 3% for our fixed income portfolio instead of using historic actual – I don’t think we are likely to ever see those 14% treasury bonds again – we have a median market value at the end of 30 years of $68,391 and a withdrawal of $2,155 in today’s dollars (with the actual withdrawal dropping to $5,147).
What you give up in potential portfolio growth and potential withdrawals with the 100% equity portfolio you get in the ability to sleep better at night knowing that your money is invested in a less risky asset allocation. However, you have to understand that inflation is a nasty creature and it will eat away at your purchasing power if you do not have adequate growth included in your portfolio.
So what is important to know about this exercise? Having an equity component in your portfolio is critical to sustaining your purchasing power for the 5% distribution. The higher your equity percentage, the more risk you assume, but by maintaining your investment allocation you weather the storm (remember we have had several 40%+ stock market crashes in the history of the stock market, with a 90%+ included for good measure) and are able to sustain your lifestyle in retirement.
Now the caveats: as with any simulation, it is just that, a simulation. It is not a Nostradamus quality prediction of the future, but rather a probability based upon a mathematical model developed by humans who are not perfect. However, it is the best tool around at the present time and given that it uses the law of large numbers to analyze the portfolio under a thousand scenarios that have happened in the past, from a statistical standpoint we can rely upon the results.
If you are wondering what the tie-in is with Kashmir and this post, there were rumors long ago that this song referred to Nostradamus predictions. Just a weird factoid from you humble blogger.
There is so much talk about how index funds are better than active management that I wanted to take a couple of minutes to show you a comparison.
In the above graphic, you see the the index fund asset allocation of 60% US Stock Market (inclusive of Large Cap, Mid Cap and Small Cap weighted in the percentage of market value each plays in the total) and 40% US Bond Market (inclusive of Corporate Bonds and Treasury Bonds weighted again by percentage of market value) which is called Portfolio 1.
Portfolio 2 is a diversified asset allocation very similar to the one we have in our Fully Diversified Strategy. It includes decisions by an investment manager (me) to allocate specific percentages of the portfolio to Growth Vs Value stocks, Large Cap Vs Mid Cap Vs Small Cap stocks, and Domestic Vs Foreign Vs Emerging Market stocks – in other words, applying the sound investment principals of risk management, relative value, and potential return, all of which are moving targets based upon the constant changes in the markets.
If you believe the hype, then Portfolio 1 will soundly outperform Portfolio 2 because no one can beat the market and that the lower fees of the index funds provide the advantage over active management.
Below is the comparison of the actively managed portfolio to the index portfolio:
If you happen to double click on the image above, you will see that the actively managed portfolio has soundly beaten the index fund portfolio. In the example above, both portfolios had $10,000 invested in 1984. Over the course of 30 years, the actively managed portfolio grew to $222,507 whereas the index portfolio grew to $172,387.
Now, I know some of you out there are thinking that the difference between the two is that Portfolio 1 did not include any foreign stocks and that if you add those in, the results are similar.
Check this out:
If you double click the image, you will see that we have added 15% International exposure and reduced the US exposure by the same amount. I chose this 15% because it is roughly the same as the 16% in Portfolio 2.
Here are the returns:
The addition of 15% International Exposure to the index portfolio made no material difference in the final portfolio value: $172,037. In fact, the portfolio value actually dropped with the addition of International stocks.
Lastly, I also want you to see how an investment in the markets did compared to keeping the money ultra safe in a money market fund. So, here is our new Portfolio 3, an all money market portfolio:
The primary reason that people keep money in a money market instead of invested prudently is that they are afraid they will lose everything and end up flat broke. However, over the course of 30 years, with multiple crashes in the stock market, inflation, wars, bad Presidents, and anything else you can think of, a properly diversified actively managed portfolio of stocks and bonds is clearly the winner. Just take a look:
I will admit that I am biased to active management over passive index funds. However, having an extra $50,000 in my investment account simply because I hired a competent investment manager who can balance Risk Vs Return by selecting an asset allocation that aims to minimize risk and maximize return seems like a simple decision, even for a banker.
Just a short note to let you see what happened to the stock market when the Fed released its meeting notes. It was no surprise to read that they were concerned about global growth and slowing US economic numbers so they put off the September rate increase until later.
The Skynet kicked into gear and pushed the index above the 50-day moving average that we looked at yesterday as resistance to close at a reading of 2013.
Below is the same graph from yesterday except updated for today’s action.
If you double click the image you will see that we moved decisively above the 50-day moving average, but the short-term indicators we looked at yesterday (RSI and CCI) are both also decisively into over-bought territory.
I still see a pullback, but it will be interesting to see if the 50-day has turned into support from resistance. Long time readers of the blog will remember my Rule of 3 – any break of support or resistance has to be sustained by either 3% or 3 trading days. If it falls (or rises) back below previous resistance (or above previous support) then breaking those levels does not count.
Also of note, our intermediate term indicators have moved more solidly positive with today’s market action – a positive thing for the intermediate future.
So, tomorrow will be a really interesting day – will we finally get the pullback that the RSI and CCI tell us is coming and can the 50-day act as support? Or, is there any chance we will knock on the door of the 200-day moving average and see the RSI and CCI get REALLY over-bought?
When I wrote a few days ago that we were waiting for the market to move 5% off its low so that we knew if we had successfully put in a double bottom, I didn’t think we would have an alm ost straight line higher. However, if you look at the price graph above (the largest of the panels in the image) you can see that we’ve had six positive days with only one slightly down day.
The price graph put in a an almost classic “W” formation with the double bottom acting as the bottom of the W, the two outside lines are higher than the two inside lines. The only thing we are missing is the right side of the W being higher than the two middle lines.
The thick red line that is sloping downward is the 50-day moving average. It is acting as resistance to further movement higher in stock prices. Note that we ended the day less than one S&P point from the line after moving above it mid-day and closing below it. My best read on this situation is that we are due for a day or two of selling pressure based upon two of the short-term technical indicators below the price graph.
If you look, you will see a red circle with a green arrow in it; the arrow is pointing to the Relative Strength Index (RSI) and it is nearly over-bought (ie, the market has moved too high too fast). Right below it, you will see a blue circle with a green arrow point to the other indicator, the Commodity Channel Index (CCI). It is giving us an over-bought signal as well. F
However, the intermediate term indicators (see the green arrows that do not have circles around them) all show strength in the current move off the double bottom. The likelihood is that we will have those couple of days of selling pressure then resume the upward movement in price, rising above the 50-day moving average line and head toward the 200-day moving average line which currently stands at 2060 on the index.
Two of these intermediate term indicators bother me and show that scenario is not 100% foolproof. One is the Moving Average Convergence Divergence (MACD) indicator; it is an intermediate term trend indicator and currently shows that we are overbought and that a change in trend is possible (see the green circle with the red arrow). The other is the On Balance Volume (see the green box) which has stopped at its moving average line.
All of the indicators at the bottom are showing that the intermediate term looks good for stock prices, so these two could just be an aberration.
My plan is to continue to stay with this market until we start moving toward the 2060 level. Somewhere in the 2025 area I’ll start to book profits on the positions we purchased when the market was lower so that we have cash on hand again if the market heads lower and can’t breach the 2060 level.
If the markets start to fly higher, moving decisively through the 200-day moving average, we will likely continue to hold our cash until we see if the index can break through to a new all-time high in the 2125 area. If it does, I will be surprised (pleasantly so since we will be making nice money), but there is very little that is text book about today’s markets when the computers are running things on Wall Street and human logic and emotion seem to be sidelined.
Check back here for more updates on the market and how we are managing client portfolios during this volatile time.
Double click on the image to see a full sized view
As a follow-up to yesterday’s post, I wanted to update you on today’s activity in the S&P 500 Index.
We opened the day down after the news broke of only 140,000 new jobs being created last month and that the previous two months numbers were revised down 40,000 as well. This news of a slowing economy, on top of yesterday’s PMI that showed barely positive manufacturing activity, threw the computers for a loop and they sold off the market.
But, as happens in an oversold market, dip buyers stepped in and pushed us higher throughout the rest of the day.
We closed at 1951 on the index, not too far from the 1965 level that tells us we have had a successful test of the August lows after a double bottom in the market on Tuesday. If you remember from yesterday, we need to move 5% higher from the low to have a successful double bottom – and when that happens, statistically only 5% of the time does the market fall back to the lows. Also, statistically, the average increase in the market is 40% from the lows – but just remember that is the average, not a guarantee.
With a slowing economy, the likelihood of a Federal Reserve rate hike is diminishing. That is supportive of higher stock prices even if growth slows substantially – however, if we head into a recession, all bets are off. The stock market does not like recessions, which almost invariably accompany bear markets. And with interest rates already so low, there is no ghost of a chance the Federal Reserve will be a major factor in getting us out of the recession without additional quantitative easing (ie, printing money) which will have negative consequences of its own.
That’s all for now. Have a great weekend and I’ll see you back here on the blog soon!
The graph above is a two month view of the S&P 500 Index. Look at all of that red! Visually, when you see all that red, you can picture the losing days in the market pretty vividly.
But, I also see two very positive things: (1) it looks like there was a successful test of the August low on Tuesday intraday with that candle that looks like a spinning top; and (2) the indicator at the bottom of the page is coming out of an oversold reading and appears to be moving higher.
These are all technical observations, so let me give you a little color so that you can understand the importance of the double bottom: for a successful test of a low to be considered a double bottom, you want first to have the price move up 5% above the second test. The low intraday was 1871 on the index, so 5% above that is 1965 on the index. We closed today at 1923, so we have not passed the test, yet. However, if we do move above 1965, there will be A LOT of resistance – just look at all of those red candles leading up to the August low. It will be a tough move higher because those red candles represent lots of selling pressure – there will likely be a number of investors that didn’t get to sell previously that will take advantage of rising prices to sell in a move off these lows.
However if we have seen a successful test, then statistically based upon the market’s history, the average rise off the bottom is 40% with a failure rate of 5%. That gives you pretty good odds to invest some capital here at these levels even if this turns out not to be the successful test.
So, we are slowly adding to positions and committing more of the cash we raised earlier in the year because the odds are in our favor.
That’s it for now – as other observations come to light I’ll pass them along.