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Relief Rally Recovery – Will It Last?


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Even though we started the quarter on a positive note, three major items hit the news that drove stock prices down by the largest and fastest amount on record.  We all know that the corona virus has shut down much of the country and it has been one of the primary catalysts of the pullback in the stock market.  Many of us have heard about the oil production dispute between Russia and Saudi Arabia that drove down the price of oil to levels not seen since the early 2000’s – energy companies now make up just 3% of the market capitalization of the S&P 500, the smallest percentage ever.  Fewer of us have heard about the financial system liquidity crisis in Europe that has driven the value of the dollar to near record levels versus the euro and has caused our Federal Reserve to provide collateralized loans to European banks and even European Central Banks.  If you haven’t read the two previous blog posts, a few things written here are discussed more in-depth in those plog posts.

From the market’s peak on February 19th to its crash low on March 23rd, the S&P 500 was down 34%.  It has since moved 20% higher as of this writing, but it remains down 20% from the top.  In the previous blog post of March 23rd, I provided you with a graph showing that the market had sold off to five standard deviations from the 10-month moving average – move in the markets that is nearly unprecedented.  Given the dept of the crash, we should not wonder that the market has moved up as fast and furious as it has.  As you can see in the graph below, we are currently within two standard deviations of the 10 month moving average, a normal trading range.


The question that everyone is asking is whether the worst is over and will the market return to its previous highs.  Bear markets in stocks rarely go straight down then straight up.  Howard Marks, a well-known investment manager, recently wrote: “In 15 bear markets since 1950, only one did not see the initial low tested within three months.  In all other cases, the bottom has been tested once or twice.”   To illustrate this statement, he provides a grid of returns for the last two bear markets as they tried to move from crash to recovery:

2000 DotCom & 9/11 Attack Crash                              2007 Subprime Mortgage Loan Crash

09/01/2000 to 04/04/2001:     -27%                            10/09/2007 to 03/10/2008:      -18%

04/04/2001 to 05/21/2001:      +19%                           03/10/2008 to 05/19/2008:      +12%

05/21/2001 to 09/21/2001:      -26%                             05/19/2008 to 11/20/2008:      -47%

09/21/2001 to 03/19/2002:      +22%                           11/20/2008 to 01/06/2009:      +25%

03/19/2002 to 10/09/2002:      -33%                           01/06/2009 to 03/09/2009:      -27%

As you can see, the typical pattern is to experience the first leg of the crash, then recover part of the loss, then make successive ups and downs as the buyers struggle with the sellers to gain ground.  Knowing this, we must be ready for the current upward move in the markets to top out and another down leg to commence.  As such, we are keeping an eye on the various indicators we follow that help us get a feel for which way the market is headed, things like valuation, breadth, momentum and trend.

If you review the graph at the top of the page, you will see a depiction of the current market.  I have annotated it to show you the depth of the loss and the current recovery, but I’ve also included various levels and a potential pathway for the stock market that is our game plan on how to play the potential ups and downs by raising and reinvesting cash to manage risk and to maximize returns.

You can see that our first level to watch for a Relief Rally Recovery is in the 2800 to 3000 area of the S&P 500 – this is a move off the lows that I’ve assigned a 75% chance of happening.  I have also assigned a 25% chance that things economically and virus-wise could get worse from here and you can see the lower level of that trading range noted on the graph.

I have three zones marked on the graph, the first of which is the Relief Rally Recovery Zone where I expect us to rally to in this first leg up off the bottom.  The two bottom levels of each are given a 75% chance and a 25% chance of a bottom in this bear market.  Each range is denoted by their likelihood of either a short-term cyclical bear market or a more extended secular bear market (see previous blog post for more in depth discussion).  Right now we have assigned a 75% chance of a short-term cyclical bear market that will lead to new highs – but if we are locked down in the stay at home policy for a longer time than currently anticipated, the recession we move into would be longer and deeper than expected currently and a longer-term secular bear market would ensue that could take a longer time to move back to new highs.

We are fast approaching the area of the graph I have noted as Relief Rally Target Zone, with the market currently at 2750 as I write this.  Our assessment is that once we get into or near this area, we will pull back a bit then head higher in a series of up and downs that will eventually lead to a test of the February low ultimately followed by a move to new market highs – but the moves up and down will likely look much like the bear market gains and losses detailed above in the two most recent bear market crashes.

Obviously, no one knows were the market will go – in fact, despite the overwhelming historic precedent for the market testing the crash low, we could have a market that does go straight back up to the old highs.  We must be prepared for any scenario that the market throws at us.  By watching the various indicators, we follow, we have a good idea what to do based upon the behavior of other investors.  The indicators are just a graphic representation of investor sentiment and the actions they take in the market which help us determine when they move from a herd of buyers to a herd of sellers and back again.

These indicators are why we have been writing to you about our risk management process that raises money as the market gets over-valued.  It allows us to have cash on-hand to invest when the market goes down and be a buyer when everyone else is a seller.

As the market turned the corner at year-end, we started adding stop loss orders on many of our holdings.  We had accumulated such nice gains that we didn’t want to give them up in case of a market correction.  Those started to hit as the market went down, automatically raising cash for us that allowed us to be a buyer of equities at levels lower than we had seen just weeks prior.  Did we catch the absolute low?  Yes and no – yes we were a buyer on March 23rd, the day of the low, but we were also a buyer on other days after the market crash began.

Our stock market risk management process of raising cash then reinvesting it when the market goes down allowed us to out-perform our benchmarks by over two percent in many of our strategies.  It also gave us the opportunity to employ a new investment strategy that repositions our clients’ stock portfolios to areas of the market that should prosper if the current stay at home policy to confront the Corona Virus drives the economy into recession.

That stock portfolio strategy we have implemented focuses on high growth companies that should continue to make money during economic downturns – things like technology companies focusing on cloud related products and biotech companies focusing on critical disease prevention and treatment – as well as defensive companies that provide products and services that we all use no matter what the economy does – staples like food and beverages plus utilities like water and electricity.  The strategy reduces exposure to energy, industrials, and materials (except gold) and it repositions financials from banks into companies that have little interest rate risk exposure.

The three causes of the crash detailed above didn’t just impact the stock market – the bond market was also impacted.  Bond yields crashed to historic lows as bond prices soared higher.  Bonds are viewed as a safe space to hide from volatility in the stock market, so as the stock market correction started to gain steam, the money that came out of stocks went into bonds.  Couple that with money coming out of Europe that was fleeing negative interest rates there turned into a tidal wave of cash coming at the bond market.   This led us to employ a new bond market strategy.

The bond market strategy we have implemented focuses on short-term high-quality bonds and adjustable rate bonds.  This strategy is driven by rates being at all-time lows yielding significant interest rate risk.  To manage this risk, bonds need to be positioned so that potentially rising rates do not cause losses to principal value of the bonds.  Short-term bonds and adjustable rate bonds have lower interest rate risk for investors and as such are the preferred choice when rates really have only one direction to go – up.