After throwing off an initial weekly sell signal back in late April prompting us to increase cash and fixed income and reduce equity exposure the markets are now beginning to wrestle with extreme oversold conditions on a short term basis. It is very important at this juncture that you understand that the trend of the market is now negative and risk management is key going forward from here.
This is a very hard concept for most investors to understand and we have written several missives lately about the basic rules of investing that should NOT be broken but are done so daily by investors who are “hoping” for one thing or another to occur rather than “understanding” and “dealing” with the facts as they are presented. In our role as portfolio managers “risk management” is not a light switch action of being “all in” or “all out” – we are not playing a hand of Texas Hold’em.
However, we do administer a rheostat approach to money management of dialing up and down exposure to risk assets as the market action dictates. At the current time all of our indicators that we track are still showing that there is more risk to being invested in the markets than potential for reward in the intermediate term (3-6 months) but there may be a short term (3-6 week) opportunity approaching for a tradable rally. The goal is not to panic sell at at temporary bottoms, our shorter term analysis indicates that we should get a rally in the next few days to allow us to more safely re-balance portfolios into.
Take a look at the chart above and notice the RED box that highlights the market topping process from July of 2007 through August of 2008. That was a 13 month topping process that finally culminated in the bear market.
IMPORTANT NOTE: The financial crisis of 2008 was the catalyst that pushed the markets into the ultimate bear market crisis. However, the bear market was already in process long before the event occurred. While the next bear market will not be the result of a “Lehman Event” there will be some crisis that will act as the “straw” to break the markets into a full blown bear market decline. If you take a look at the world around us today there are many possible events from geopolitical, financial and economic events of which anyone would be sufficient to induce an average bear market decline of 30% or more.
Notice that the dotted blue line during the topping process in 2007 denotes the neckline of the “head and shoulder” pattern that formed at that time. The same pattern, much more distinguishable this time, occurred and was broken this summer. The similarities currently in the action of the market are quite similar in both periods after the market broke the “neckline” the indices declined to the lower band (2 standard deviations below the 50 week moving average) and bounced.
The first bounce in 2007 was a failed attempt that led to a lower low before rallying back to the 50 week moving average. That is where we are today. The markets are currently at the bottom of normalized trading ranges and should attempt an “oversold” rally to the 50 week moving average. A rally of that magnitude will do several things:
- It will take the index to approximately 1225-1250 depending on how soon the rally starts.
- It will get investors, and primarily the media, all excited that the markets have now bottomed and we are on the path to the next great “bull” market.
- Investors and speculators will ignore all warnings of risk and plow into the most highly speculative market issues.
As it did in 2007, this rally will be a “suckers” rally which will draw investors in only to leave them, most likely, battered, bruised and bleeding. This rally will most likely be the last best chance to reposition portfolios for the next potential decline until the markets have formed a more intermediate to long term bottom. The good news here is that we will truly get valuations based on reported trailing twelve month earnings to levels more normally associated with successful long term investing.
In the meantime, be patient here, don’t panic sell but do use rallies to your advantage. Remember the two basic tenants of investing:
- In a bullish (rising) trend – buy dips.
- In a bearish (falling) trend – sell rallies.
We are clearly in a negative, or bearish, trend which means that until that changes (and it will eventually) investors should consistently sell into rallies and raise cash and fixed income positions.