Why Dave Ramsey Is Wrong & What You Can Do To Build A Tax-Free Nest Egg.
Over the last couple of weeks, the market has been working off the overbought condition that accrued from the surge off the February lows. As I wrote recently:
“With the markets still extremely overbought from the previous advance, the easiest path for prices currently is lower. The clearest support for the markets short-term is where the 50 and 200-day moving averages are crossing. I currently have my stop losses set just below this level as a violation of this support leaves the markets vulnerable to a retest of February lows.”
“On a short-term (daily) basis, the current correction is still within the confines of a more normal “profit-taking” process and does not immediately suggests a reversal of previous actions. As shown in the chart above, support currently resides at 2020 & 2040 with the 50-day moving average now trading above the 200-day. “
The yellow band in the chart above is the ongoing trading range the market has remained mired in since May of 2014.
As I have stated in the past, by the time a rally occurs that is strong enough to reverse bearish signals, the market is generally extremely overbought. The market must then work off that overbought condition before the next advance can occur.
“The current correction was not unexpected. It was a function of time before the extreme short-term extension of the market corrected. Like stretching a rubber band to its limits, it must be relaxed before it is stretched again. The question is whether this is simply a “relaxation of the extension” OR is this a resumption of the ongoing topping and correction process?”
It is the last part of the statement above that I want to address this week.
Is this just a correction within the confines of a bullish advance OR is the recent market action just a continuation, and eventual completion, of a market topping process?
The answer: It depends on your investment time frame.
If you are a trader with a time horizon that is from days to a couple of months, the backdrop to the markets are currently more bullish than bearish. As shown below, the number of advancing stocks has broken out of recent downtrends which has historically related to more bullish underpinnings.
However, if you are a longer-term investor, particularly within a couple of years of retirement, market dynamics are still exceedingly negative. As shown below, despite the recent surge in the market, not unlike that seen in Oct 2014 and 2015, is still contained within a topping process as witnessed during the peaks of the previous two bull markets.
As Michael Kahn penned this past week in Barron’s:
“Like life, the stock market is rarely black or white. Right now, however, the outlook is particularly muddled. In technical analysis, when moving averages cross over each other to the downside we call it black. When they cross to the upside we call it golden. Now, the market is giving off mixed signals, making it no more than a bland beige.”
This is a problem for investors, who despite saying they are long-term investors are always driven by short-term market swings which impact emotional biases. He concludes:
“There is a good argument that stocks are ripe for a correction after a sharp rally, but with the undercurrents in sectors, interest rates, and breadth there is not enough evidence to hand the reins over the bears. Bulls, however, do not have much room for error. The falling U.S. dollar may be the handwriting on the wall, and the Fed better be very careful with its decision at next month’s meeting.”
It is this ongoing “limbo” that continues to weigh on investor sentiment. While the “bulls” have once again emerged onto the field, there is not enough “evidence” currently to suggest an aggressive risk posture in portfolios.
As Bill Henry once quipped:
“It is better to be out of a bull market than fully invested in a bear market.”
This idea of elevated risk is clearly prevalent in the analysis by David Keohane via Financial Times.
“HSBC’s FX team last week as they reissued their RoRo charts and warnings. Remember, red means strong positive correlation, blue means strong negative correlation, green and yellow means correlations are heading to zero. So, as HSBC say: the RoRo ‘paradigm’ can be defined by three key features:
- “Risk-on” assets are positively correlated with each other
- “Risk-off” assets are positively correlated with each other
- “Risk-on” assets are negatively correlated with “risk-off” assets
This is what those correlations look like now:”
“This, from a previous post in 2012, shows what that chart looked like pre-Lehman and in a strong RoRo period in 2012:”
“Remember too that RoRo very probably comes into its own when assets markets face extreme, near binary, outcomes. Think just after 2008 when, as HSBC put it, ‘events happened which changed the consensus probabilities being ascribed to… two outcomes, there were large, synchronised price moves in most asset classes. So the crux of our explanation for RORO is a highly-volatile market consensus.’”
Here is the important point that David points out as the key problem as the effects of QE wane.
“… as soon as the Fed actually raised rates, fear set in and 2016 began with worry, uncertainty and very negative sentiment. In addition to worries over the Fed hiking cycle, there were heightened concerns over weakening oil prices and the growth and policy outlook for China. Risk assets were punished during this period. From mid-February, however, sentiment shifted suddenly. Since that point risk has very much been on; risk assets have rallied and the fear of missing out is now crowding out the fear of losing money.
These sudden shifts in consensus are bringing RORO correlations to the fore again and investors are once more obsessing about whether we are in a risk-on or risk-off period.”
By reducing the markets to a much more simplistic analysis, and removing the emotionally driven biases from the investing process, we begin to see a clearer picture of the potential risks to aggressively allocated portfolios.
So, as I stated above, the decision about whether this is a bull market or an ongoing correction process is really about time frames.
The biggest mistake that investors make, hands down, is the failure to match their investment time horizon to their allocation structure. This is called “duration matching.” If you have a short-term window to your goals but build a long-term portfolio model, things will likely not work out well for you.
I have written in the past about the historical precedent of “Sell In May & Go Away.” Every year, there is always a litany of articles written about why it is such a bad idea, you need to just buy and hold, blah…blah…blah.
Last year, selling in May, as I recommended, saved your bacon a lot of grief during the August dive.
However, there are indeed some years where markets rose during the summer months.
“Opps…you missed out. What a loser you are.”
For a moment set aside the inherent biases of media and investment firm publications designed to keep you invested at all times so they can collect a fee or ad revenues. Instead, let’s discuss the “Sell In May” issue from a more technical and statistical basis.
First, “selling in May” does not necessarily mean going to cash. Can we please stop using extremes to try and prove a point.
“Selling In May,” at least in my world, is the process of reducing risk during a period time where historical returns have tended to be poor. Take a look at the chart below which shows a $10,000 investment into markets during the “Seasonally Strong” vs. “Seasonally Weak” periods. Did you really miss anything by skipping the summer months?
Let’s dig a little deeper. Just recently, Carl Swenlin at Decision Point published the following tidbits.
“The chart below shows the favorable six-month period just ended, and we can see that SPY closed less than one point above its starting point at the end of October. Technically, it fulfilled its positive expectations, but as a practical matter the sharp decline into the February low would have made holding a long position based solely on seasonality a painful experience.“
“Now let’s look at the last six-month unfavorable period from May 1, 2015 through October 30, 2015 on the chart below. It is amazingly similar to the favorable period just ended. Negative expectations were fulfilled with the turbulence in August and September, but price recovered so that SPY closed slightly above the May starting point.
“Now let’s go back one more period to the favorable period from November 2014 through April 2015. Finally, we have a period that meets bullish expectations without a great deal of volatility.”
“While the title of this article announces the end of a favorable period, the real news is that a new unfavorable six-month period will begin on Monday, and we are reminded of the old saying, ‘Sell in May, and go away.’ Unfortunately, we can see from the first two charts that seasonality rules are not always reliable. Rather, it is important to remember that seasonal tendencies will be working to pull prices down. Whether or not negative seasonality will prevail over more positive forces that may materialize we can’t know, but we should be aware of historical tendencies that will be influencing the market for the next six months.”
Carl is absolutely correct. It is not whether the summer is negative that is important, but the amount of volatility that you suffer in the meantime. Furthermore, when you combine seasonality with weak earnings and a Presidential Election; you have all the ingredients needed for a “sit on the sidelines” portfolio.
In other words, by the end of summer, we may be no better off than we are right now.
Just something to think about.
“There is only one side to the markets; it is not the bull side or the bear side, but the right side.” – Jesse Livermore
On a short-term basis, the ongoing correction last week took the market back to its rising 50-day moving average and has worked off the overbought condition that previously existed. Importantly, on Friday, the market defended the 50-dma and turned back into positive territory for the day.
As I have noted in the chart above, the yellow highlights point out the short-term oversold conditions which have been previously consistent with a market bounce. With the market defending the 50-dma on Friday, combined with the short-term oversold condition, a bounce early next week is likely.
However, this does not mean the markets are ready to go soaring back to new highs. As shown these bounces can, and have been, very short-lived in many cases.
The bounce on Friday was also important as the market defended the 400-day moving average as well. Just as I showed above, the combined defense of support at the 400-dma with an oversold condition suggests that markets are set up for at least a short-term bullish advance.
As stated above, while the very short-term indicators suggest a more bullish backdrop going into next week, I do want to continue to issue a word of a caution:
Furthermore, as shown below, the current advance and topping process, remains in the confines currently of a “lower high and lower low” scenario. While it may not “feel” that way, we are still within the broader confines of a downward trending market. As I stated last week:
“The last time the same combination of signals existed was in November of last year. The resulting outcomes were not pleasant for most investors. There has not been a fundamental or economic development to suggest ‘this time is different.’ In fact, in many ways, it is worse.”
As I have repeatedly stated over the last couple of weeks the current market setup feels like a “trap.” I remain cautious and already have an “inverse market” position loaded in our trading system to move portfolios quickly back to market neutral if markets break support.
In the short-term, bullish dynamics are in place giving short-term investors and traders an opportunity to put capital to work.
However, for longer-term investors, and particularly those with a short time-frame to retirement, let me leave you with the recent conclusion from Stan Druckenmiller of Duquesne Capital:
“If we have borrowed more from our future than any time in history and markets value the future, we should be selling at a discount, not a premium to historic valuations. It is hard to avoid the comparison with 1982 when the market sold for 7x depressed earnings with dozens of rate cuts and productivity rising going forward vs. 18x inflated earnings, productivity declining and no further ammo on interest rates.
The lack of progress and volatility in global equity markets the past year, which often precedes a major trend change, suggests that their risk/reward is negative without substantially lower prices and/or structural reform. Don’t hold your breath for the latter. While policymakers have no end game, markets do.”
The Sector Allocation Rotation Model (SARM) is an example of a basic well-diversified portfolio. The purpose of the model is to look “under the hood” of a portfolio to see what parts of the engine are driving returns versus detracting from it. From this analysis, we can then determine where to overweight sectors which are leading performance, reduce in areas lagging, and eliminate those areas that are dragging.
GOLD BUG NOTE: I have had a tremendous number of requests to include “that special shiny metal” into the weekly SARM analysis. Beginning this week, that request has been fulfilled.
Over the last five weeks, RISK based sectors have continued their streak of improvements as money has flowed out of perceived areas of SAFETY.
The rotation from defensive to “risk on” sectors is now complete:
LEADING: Energy, Materials, Industrials, Mid-cap, Small-cap, Discretionary. (REIT’s are leading as investors chase risk and yield. Financials are rapidly improving playing catch-up)
LAGGING: Utilities, Gold, Bonds, Staples, Technology, Healthcare
The sector comparison chart below shows the 9-major sectors of the S&P 500.
The best sectors for short-term traders to over-weight next week remains:
Discretionary, Industrials, Materials, Staples, Energy, Utilities and Financials.
This is also shown in the sector analysis tables below.
As stated above, the SARM Model is an “equally weighted model” adjusted for risk. The current risk weighting remains at 50% this week. It will require a move to new all-time highs in order to safely increase model allocations further at this juncture.
Relative performance of each sector of the model as compared to the S&P 500 is shown below. The table compares each position in the model relative to the benchmark over a 1, 4, 12, 24 and 52-week basis.
Historically speaking, sectors that are leading the markets higher continue to do so in the short-term and vice-versa. The relative improvement or weakness of each sector relative to index over time can show where money is flowing into and out of. Normally, these performance changes signal a change that last several weeks.
The last column is a sector specific “buy/sell” signal which is simply when the short-term weekly moving average has crossed above or below the long-term weekly average. The number of sectors on “buy signals” has improved from just two a few weeks ago to 10 this past week. Sectors that are on buy signals tend to outperform in the near term.
The risk-adjusted equally weighted model remains from last week. No changes this week.
The portfolio model remains at 35% Cash, 35% Bonds, and 30% in Equities.
As always, this is just a guide, not a recommendation. It is completely OKAY if your current allocation to cash is different based on your personal risk tolerance, time frames, and goals.
For longer-term investors, we need to see an improvement in the fundamental and economic backdrop to support a resumption of the bullish trend. Currently, there is no evidence of that occurring.
There are 4-steps to allocation changes based on 25% reduction increments. As noted in the chart above a 100% allocation level is equal to 60% stocks. I never advocate being 100% out of the market as it is far too difficult to reverse course when the market changes from a negative to a positive trend. Emotions keep us from taking the correct action.
As discussed in the main section of the newsletter, the short-term dynamics remain bullishly biased for the moment. However, the longer-term structures still remain negative with the market potentially in a broadening topping process. The question at the moment is who will win: Fundamentals (bearish) or Fed (bullish).
Historically speaking, fundamentals have tended to “Trump” (pun intended) everything else.
Last week, the market retraced enough to work off some of the overbought condition and test support at the 50-dma. If you are still grossly underweight equities, and have been looking for an opportunity to move portfolios to current target levels – this is as good of a setup as we can get. However, as always, there are no guarantees.
While our intermediate-term buy signals are in place, we must wait for a breakout of the markets to new highs before increasing the allocation model further. If such occurs, the model will quickly move in steps back to full equity allocations. Currently, however, the risk/reward ratio does not warrant a further increase at this time.
Therefore, we continue to wait for either a breakout of the market to new all-time highs, or a breakdown below support reversing recent actions. I will admit remaining trapped in “limbo” is emotionally trying – but this is where investors typically make the biggest mistakes by trying to “guess” at what the market will do next. We are better off to wait and let it “tell” us.
Since 401k plans have limits to switching funds to limit turnover, I continue to reiterate caution:
“With the technical damage to the market remaining over the intermediate and longer-term time frames, the reward of aggressively increasing allocations currently is still outweighed by the risk. So, any equity additions should be done with extreme caution and an “itchy trigger finger.”
For longer-term investors, the markets have made virtually no progress since January of 2015. Therefore, there is little evidence to suggest stepping away from a more cautionary allocation…for now.
If you need help after reading the alert; don’t hesitate to contact me.
The 401k plan allocation plan below follows the K.I.S.S. principal. By keeping the allocation extremely simplified it allows for better control of the allocation and a closer tracking to the benchmark objective over time. (If you want to make it more complicated you can, however, statistics show that simply adding more funds does not increase performance to any great degree.)
The list below shows sample 401k plan funds for each major category. In reality, the majority of funds all track their indices fairly closely. Therefore, if you don’t see your exact fund listed, look for a fund that is similar in nature.
Lance Roberts is a Chief Portfolio Strategist/Economist for Clarity Financial. He is also the host of “The Lance Roberts Show” and Chief Editor of the “Real Investment Advice” website and author of “Real Investment Daily” blog and “Real Investment Report“. Follow Lance on Facebook, Twitter and Linked-In