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EDITOR’S NOTE:  There will be NO newsletter next week as I am traveling. However, if something critically important happens I will pen a brief note. Make sure you are registered at the website for important updates and allocation model changes.

Last Tuesday, I discussed the market’s breakout to the upside and the increase in equity exposure in client’s portfolios. To wit:

“From a technical basis, looking at the structure of the trend, and given the probability it is in the latter stages of this particular bull market, we have likely seen the S&P 500 just complete a large consolidation, as mentioned above, concluding Wave 4 of the Elliott Wave principals. This suggests that a Wave 5 has begun (the last part of the trend sequence) which will coincide with the ‘market melt-up’ phase of this advance before the next major correction begins.”

“Theoretically, once a small correction action that maintains the current bullish-trend works off the current “overbought” condition, the blow-off speculative Wave 5 impulse move should begin.

Wave 5, ‘market melt-ups’ are the last bastion of hope for the ‘always bullish.’ Unlike, the previous advances that were backed by improving earnings and economic growth, the final wave is pure emotion and speculation based on“hopes” of a quick fundamental recovery to justify market overvaluations. Such environments have always had rather disastrous endings and this time, will likely be no different.”

Buying Because I Have To. You Don’t.

Let me repeat what I wrote the last time as things have not changed.

“I am buying this breakout because I have to. If I don’t, I suffer career risk, plain and simple.

But you don’t have to. If you are truly a long-term investor, this rally is just a rally. There is no confirmation fundamentally the bull market has yet resumed. Such leaves investors with a tremendous amount of downside risk relative to the reward that is currently being offered.

However, investor patience to remain conservatively invested while what seems like a “bull market” is in force is an extremely difficult thing for most to do.

So, if you buy the breakout, do so carefully. Keep stop losses in place and be prepared to sell if things go wrong.

It is important to remember that the majority of those touting the bull market are simply just getting back to even after an almost year-long sludge. For now, things are certainly weighted towards the bullish camp.

However, such will not always be the case.”

What Happens Next Determines Action

This week, I am adjusting the model allocations up to 75%. Review last week’s missive for the individual sector analysis for recommendations leading up to the model change.

However, while I am changing the model, this does not mean going out and clicking the “buy” button on everything you can find. We must now wait for the right entry point to increase equity allocations to the new model weights. 

As shown below, the market is currently 3-standard deviations above its 50-day moving average. This is “rarefied air” in terms of price extensions and a pullback is now necessary to provide a better entry point for increasing equity allocations.

However, as I have noted, there is a difference in pullbacks.

1. A pullback to 2135, the previous all-time high, that holds that level will allow for an increase in equity allocations to the new targets.
2. A pullback that breaks 2135 will keep equity allocation increases on “HOLD” until support has been tested.
3. A pullback that breaks 2080 will trigger “stop losses” in portfolios and confirm the recent breakout was a short-term “head fake.”

While the breakout this week is certainly “bullish” and should not be dismissed lightly, it is valid if the breakout holds. However, as I noted on Tuesday, the rotation from bonds to stocks is confirming the push higher currently. Much of the sustainability of the rally going forward is dependent upon the ongoing rotations from “safety” back into “risk.” 

Disclosure Note: I did take a short position against bonds on Monday with a target of 1.7-1.8% on the 10-year Treasury. (TBT)

Importantly, despite the breakout and increase in bullish exuberance, the markets are overly extended, overly bullish and excessively complacent. Such a combination of factors greatly increase investment risk.

However, given the long consolidation process of the market since May of last year, the markets are confirming their ongoing bullish trend. As stated above, this requires me to increase equity exposure to 75% of target weightings. After such an extended run in the markets, this seems somewhat counter-intuitive. It is. But, as Bill Clinton once famously stated; “What is….is.” 

While the market “IS” currently acting bullishly, it doesn’t mean such will always be the case.

As investors, we must modify Clinton’s line to: “What is…is…until it isn’t.”  We must be able to recognize, and be responsive to, changes in underlying market dynamics if they change for the worse and be aware of the risks that are inherent in portfolio allocation models.

If the bullish trend holds, works off the excessive overbought conditions and resets investment risk, the models will be adjusted back to 100%.

A Quick Note On Portfolio Management

Here are the guidelines to follow in adjusting your portfolio allocation model.

1. Move slowly. There is no rush in adding equity exposure to your portfolio.  Use pullbacks to previous support levels to make adjustments.

2. If you are heavily UNDER-weight equities, DO NOT try and fully adjust your portfolio to the model in one move. This could be disastrous if the market reverses sharply in the short term. Again, move slowly.

3. Begin by selling laggards and losers. These positions are dragging on performance as the market rises and tend to lead when markets fall.  Like “weeds choking a garden,” pull them.

4. Add to sectors, or positions, that are performing with, or outperforming, the broader market. (See last week’s analysis for suggestions.)

5. Move “stop loss” levels up to current breakout levels for each position. Managing a portfolio without “stop loss” levels is like driving with your eyes closed.

6. While the technical trends are intact, risk considerably outweighs the reward. If you are not comfortable with potentially having to sell at a LOSS what you just bought, then wait for a larger correction to add exposure more safely. There is no harm in waiting for the “fat pitch” as the current market setup is not one.

7. If none of this makes any sense to you – please consider hiring someone to manage your portfolio for you. It will be worth the additional expense over the long term.

The “Rothschild 80/20” Rule

While I have often been chastised for not “chasing markets,” I am also not working my way back to even. Having been underweight equity risk in recent months has paid dividends by reducing portfolio volatility and emotional stress.

Here is my point. As a long-term investor, I don’t need to worry about short-term rallies. I only need to worry about the direction of the overall market trends and focus on capturing the positive and avoiding the negative.

As Baron Nathan Rothschild once quipped:

“You can have the top 20% and the bottom 20%, I will take the 80% in the middle.”

This is the basis of my 80/20 investment philosophy and the driver behind the risk management process.

While I may not beat the market from one year to the next, I will never have to suffer the time loss of required by“getting back to even.” In the long run, I will win.

As shown in the table below, a $100,000 investment in the S&P 500 returns a far lower value than the “Rothschild 80/20 Rule” model. This is even if I include a ridiculous 2% management fee.

But here is how it plays out over the long-term.

Yes, it’s only a couple of million dollars worth of difference, but the reduced levels of volatility allowed investors to emotionally “stick” to their discipline over time. Furthermore, by minimizing the drawdowns, assets are allowed to truly “compound” over the long-term.

Get it. Got it. Good.

So…Do I Adjust My Portfolio Now

The short answer is “NO, Not Yet.” 

As stated above, the market needs to blow off some of the excess overbought condition in the market.

Secondly, we are moving into two of the worst months of the year seasonally speaking combined with a Presidential election. It is very likely that we will see a correction in the market during this period. As Dana Lyons’ pointed out this week:

“Specifically, we have seen numerous forecasts calling for an impending stock market top, or at least a summer swoon. But while anything is possible in this market, a major market top right now would actually be unprecedented.

Why is that? Well, since 1900, using the Dow Jones Industrial Average (DJIA) as a gauge, the stock market has never put in so much as a 12-month top in the month of July.”

However, as I have noted previously, my expectations are for a correction of some sort in August and/or September. Notice the 12-month tops have occurred 5-times in September nearly tying the six in January.

For now, there are plenty of bullish arguments piling up to support markets over the next few weeks:

• Earnings estimates are exceedingly low, as we saw this past week, investors are cheering really crappy earnings reports simply because companies are winning the “beat the estimates” game.
• The improvement in oil prices, and decline of the dollar, has taken some of the pressure off of industrials, energy and material stocks which are being pushed higher.
• Economic data has been exceptionally weak early in the year, a short-lived rebound is currently in the works which will help markets temporarily.
• Share buybacks continue to be a primary support of asset prices currently. However, this support is coming primarily through leverage which has long-term negative consequences.

There is also a possibility this central bank driven liquidity push is a giant “trap” waiting to be sprung on unwitting investors. 

The current rally is built on a substantially weaker fundamental and economic backdrop. Therefore, it is extremely important to remember that whatever increase in equity risk you take, could very well be reversed in short order due to the following reasons:

1. We are moving into the latter stages of a cyclical bull market.
2. Economic data continues to remain weak
3. Earnings are only positive by not sucking as bad as estimates
4. Volume is weak
5. Longer-term technical underpinnings remain bearish.
6. It is the summer of a Presidential election year which tends to be weak.
7. Share buybacks are slowing
8. The yield curve is flattening

It is worth remembering that markets have a very nasty habit of sucking individuals into them when prices become detached from fundamentals. Such is the case currently and has generally not had a positive outcome.

The chart below illustrates point #5 above. There are still WAY too many negative divergences in underlying indicators to suggest an “all clear” for investors currently. 

What you decide to do with this information is entirely up to you. As I stated, I do think there is enough of a bullish case being built to warrant taking some equity risk on a very short-term basis. We will see what happens next week. 

However, the longer-term dynamics remain bearish. When those negative price dynamics are combined with the fundamental and economic backdrop, the “risk” of having excessive exposure to the markets greatly outweighs the potential “reward. “

Could the markets rocket up to 2200 or 2300 as I suggested earlier this week? It is quite possible given the ongoing interventions by global Central Banks.

The reality, of course, is while the markets could reward you with 160 points of upside, there is a risk of 600 points of downside just to retest the previous breakout of 2007 highs

Those are odds that Las Vegas would just love to give you. 

Please be careful.

Investing is not a competition.

It is a game of long-term survival. 

Okay, with the analysis above, let’s now set up the necessary adjustments to the model allocation so we are ready to adjust portfolios accordingly during the requisite pullback.

Step 1) Clean Up Your Portfolio

1. Tighten up stop-loss levels to current support levels for each position.
2. Hedge portfolios against major market declines.
3. Take profits in positions that have been big winners
4. Sell laggards and losers
5. Raise cash and rebalance portfolios to target weightings.

Step 2) Compare Your Portfolio Allocation To The Model Allocation.

1. Determine areas requiring new or increased exposure.
2. Determine how many shares need to be purchased to fill allocation requirements.
3. Determine cash requirements to make purchases.
4. Re-examine portfolio to rebalance and raise sufficient cash for requirements.
5. Determine entry price levels for each new position.
6. Determine “stop loss” levels for each position.
7. Determine “sell/profit taking” levels for each position.

(Note: the primary rule of investing that should NEVER be broken is: “Never invest money without knowing where you are going to sell if you are wrong, and if you are right.”)

Step 3) Have positions ready to execute accordingly given the proper market set up. In this case, we are looking for a pullback to reduce the extreme overbought condition of the market without violating any major levels of support.

Current & Target ETF Model Allocation

Click To Enlarge

Increasing Weightings In: 

• Discretionary
• HealthCare
• Staples
• Materials
• Industrials
• Utilities
• Small Cap
• Mid Cap
• REITs

No Change In Weighting:

• Technology
• International

Weighting Reductions:

• Financials 
• Energy
• Cash

Given the right “set up” to increase equity allocations, begin by “averaging up” in existing holdings in your portfolio to match model allocation and weights. When, and IF, the market confirms the continuation of the “bullish trend,” then begin adding new holdings to the model.

As stated repeatedly above, move “stop losses” on all positions up to current critical support levels and maintain a plan for “hedging” portfolio risk should something go wrong.