Week In Review (1/26/15 - 1/30/15)

This week and all of January for that matter provided a continuation of the volatility that dominated the 4th quarter of last year.  4 out of 5 days featured 1% intraday moves on the S&P.  From a simple price chart you can see the index traded in a sideways chop for the entire month.  We laid the VIX at the bottom of the to show how, unlike other recent periods, volatility has been able to sustain a more elevated level.  All in all, until we get a confirmation of a trend out of the S&P's current range a strategy based on buying strength or selling weakness will remain challenging.

Another developing worry is the potential giant topping pattern in the broader NYSE Composite. Since the index's high last July, it's made a string of lower highs coupled with some waning breadth indicators.

We wanted to share a nice post from Crosshairs Trader about the current chop.  The message in the diagram below is simple:  when the market enters one of these volatile, rangy periods it's critical to focus on positive habits while recognizing and hopefully avoiding negative thoughts and influences.

Many investors, particularly when they're struggling, will go looking for the next "best" thing.  David calls this the magic genie lamp expedition which is genius and so very true.  Successful traders develop habits that focus on process and knowing that as long as they prudently manage losses that better times will be ahead.  There is no one strategy that works in every market.  Right now, many macro trend traders are making a killing on the huge currency and energy trends.  While most momentum traders are having a difficult time.  Being patient and confident in your process while waiting out the bad times is what distinguishes good traders from the pack.  





Here's a look at some commentary and links that caught our eye during the week:

-A look back at seasonality and historical January performance

-A timely piece on investor psychology from Josh Brown given our Thursday post.

-You'll rarely see us quote Zero Hedge but the notes on this S&P 500 chart are pretty telling...

-And Charlie Bilello at Pension Partners always produces solid market observation and commentary.

Have a great weekend!

The Psychology of Markets

As the blog evolves, it will be a priority of ours to touch on as many aspects of investing and trading as possible.  We'll certainly be more educated on certain topics than others but hopefully those instances will serve as great learning opportunities. In an ideal scenario, this will be a community full of productive dialogue and interaction.

With that in mind, we intend to dedicate considerable space to the study of behavioral finance and the psychological elements of investor decision making.

Legendary value investor Ben Graham (also known as Warren Buffett's mentor) once said, "the investor's chief problem - and even his worst enemy - is likely to be himself."  Those cautionary words are just as, if not more, prevalent today than when Mr. Graham first spoke them more than a half century ago.  With the relentless amount of news flow and data available to today's investor, it comes as no surprise that so many struggle with managing their emotions and resisting impulse when making investment decisions.

Behavioral finance is a relatively new field of study in the investment universe.  For decades now, a great majority of the advice that is sold and delivered to investors is grounded in the notion that the market is entirely efficient and rational.  The Capital Asset Pricing Model and the Efficient Market Hypothesis were the backbone of finance academia and wealth managers.  These theories were laid out under the assumption that investors were, for the most part, rational in their decision making.  While admirable and neat for a classroom setting, any participant in the real world securities markets knows that irrationality, emotions and biases show themselves on a daily basis.

No matter their skill level or wealth, every investor has at some point has fallen victim to an emotion or bias and made a poor investment/trade because of it.  This is an unavoidable fact of investing but something that can also be minimized by developing a process that is adhered to strictly.

We intend to explore behavioral finance and its many branches in an effort to become better money managers.  We see it as a great way to learn - to highlight and reinforce good habits while providing the chance to expose and eliminate the bad.  Being aware of one's emotions and potential biases is absolutely critical in their growth as an investor and it's a constantly evolving process.  Every day brings about a new set of potential influences.  For example, while slightly extreme, one stain on our record was our extreme pessimism as the market bottomed in early 2009.  During that period we became so focused on further risk to the downside that we lost sight of any other potential outcomes.  We were guilty of actively seeking negative market commentary that jived with our bearish stance.  While this made us feel safe in the short term by confirming our biases it proved to be an unhealthy trait and we missed huge opportunities at the March bottom because of it.  This is just one example.  We've had some since and we'll absolutely have more in the future.

So as active investors we really need to focus on not allowing ourselves get too bullish or bearish. We must constantly challenge our current of view of trends and positions as a means of removing our biases.  It's simply a game of devil's advocate while waiting for price to either confirm or invalidate our research.  Even the best investors will have their share of poor trades, terrible trades even, but one of the key components to their success is their ability to manage their emotions and biases the great majority of the time.

We'll be revisiting behavioral finance topics frequently.  Feel free to join in on the conversation.

Looking At Trends

Wanted to offer a quick update on the longer term charts of the S&P 500 and Russell 2000 (IWM) for some perspective and potential scenarios.  

Both index's remain in long term uptrends from the 2009 bottom steadily rising between the top and bottom channel lines.  We are just looking at price charts in these examples.  The S&P 500 weekly chart has the look of a rising wedge.  A break above or below the channel lines could bring about a quick move in either direction.  Also be on the lookout for a false breakout in either direction similar to the October bottom in which we initially broke below the lower channel line.  Sellers fearing a bigger correction sold positions or got short only to be fooled once again and we raced right back up to the upper channel line.  These two boundaries are getting squeezed closer by the day and ultimately the index must resolve this.  Recently we've seen continued back and forth choppy action where weakness has been bought and strength sold.  This is characteristic of the QE influenced market of the last several years and with the ECB's announcement last week, we could be in for more.

Turning to the Russell 2000, we see that the index has essentially gone sideways for the last year.  This has created a nice long consolidation pattern that should eventually result in a sustained directional trend.  A breakout to the upside of the sideways pattern would give the index plenty of room to run until technical resistance at the upper channel line.

As for what news headlines will "cause" the indexes to break out of these ranges is anyone's guess.  With earnings on the horizon many individual stocks will be on the move while continued QE by central banks surely makes it hard to argue against the established uptrends.  Yet a black swan / unforseen geopolitical event is enough to derail any market.  As we wait for the next market moving headline, it's important to know where things stand in terms of trends and support/resistance levels and manage your risk models accordingly.  With the market firmly in a choppy range and futures pointing to a big gap down this morning, we'll be watching how the indexes react around these levels.  

S&P 500 Dividend Yield

The note below comes courtesy of Jeff Saut, chief investment strategist at Raymond James.  While such a shift in the spread of the S&P 500 relative to 10-Year Treasuries has happened on very rare occasion (3 times in the last 50+ years), it has portended to incredibly positive results for stocks.  See below:

"The table below lists each time since 1962 that the spread in yields between the S&P 500 and the 10-year Treasury moved into positive territory after not having done so for the last six months. For each period, we list the first day the dividend yield exceeded the yield on the 10-year, and then show the performance of the S&P 500 over the following one, three, six, and twelve months. As the results illustrate, each of these prior instances were great times to buy equities. Following each occurrence, the S&P 500 saw consistently positive returns, with a median gain of 7.8% just one month later to a median return of 33.4% over the following year. While these past performances don’t guarantee similar returns going forward, they are pretty compelling.

As an aside, for market history buffs, the 6/22/62 yield inversion was a result of the President Kennedy steel crisis whereby the steel companies increased prices and the President confronted that price raise with a resulting Dow Dive from 700 to 535 (-23.6%), but I digress. Consistent with the message from the good folks at Bespoke, we think the equity markets are working themselves into a good “buy spot.” Unfortunately, the “buy spot” probably does not arrive until February or March."

As Saut notes, each of the other occasions have happened at points in history when the market was at extremely oversold levels whereas today we sit near all-time highs.  This most recent instance is likely heavily influenced by the Fed's near zero rate policy so it's difficult to feel confident in expecting similar stock market performance over the next year.

But to be sure, we'll be consulting this data point over the course of the year to compare results.

Quick Note On Volatility

Volatility was incredibly tame in 2014 particularly through the first nine months of the year. In fact, the S&P 500 did not suffer a single 4-day losing streak, a feat that had never been achieved in the index's 90 year history.  Prior to September, according to the WSJ, the index had recorded only four 3-day skids while racking up 11 separate winning streaks of 4-days or longer.      

However, since Labor Day, the market has shown signs of a changing temperament.  There were six 3-day slides in the last 4 months of the year and so far in 2015*, we've already seen two separate 5-day losing streaks (*the first streak began in late December).

We're of the mind that investors, who could have set their accounts to "auto-pilot" the last two years, should be paying close attention to the market's recent chop.  While we're firmly in the camp of believers thinking we've entered a new secular bull, there's no reason the market can't have a deeper correction.  Below is a chart of the S&P with implied and realized volatility shown at the bottom.  Both the VIX and the Average True Range (ATR) have picked up significantly over the last few months.  While realized volatility has moved toward levels reached during October's 10% sell-off, the market has only fallen 5% from its most recent peak.

Further, given the gyrations and headline risk we've seen thus far in 2015, we're surprised by the relative complacency we've heard/witnessed from other investors.  That doesn't feel right to us and could be a call for further caution.

Chop Fest 2015

Jeff Gundlach was recently quoted as saying 2015 would be the year of the V.  V is for volatility.  So far his call is proving to be spot on.

In the spirit of choppiness and uncertainty, we saw significant divergence yesterday in 2 of our indicators that we considered worth sharing.  

First, we had 23 stocks in our universe up 50% or more in yesterday's session however all but 2 were in the healthcare/biotech space.  Out of that 23, 20 were strictly biotechs.  This is a level that, historically, has proven to show the market is overheated in the near-term.  If we look back at the data since the beginning of 2012 we see that in the short-term (5, 10, and 20 days) the results show little price progress versus when we are not at overbought levels.

	Nas+5	Nas+10	Nas+20	Nas+50
50% Up > 20	-0.16%	-0.29%	0.34%	2.29%
50% Up < 20	0.37%	0.90%	1.68%	3.77%

On the other hand we see a positive divergence taking shape in the difference between 20 day highs and lows.  This indicator is showing much less selling pressure as we test the early January and December lows. 

 

With current headline risk (currency market fluctuations and monetary policy announcements) making conditions ripe for wild daily volatility, many of our indicators are flashing the conflicting signals you might expect.  We're content playing light here while waiting for some more definitive evidence. 

Correlations

Today's market action prompted us to share one of our favorite measurements.    The chart below looks at the rolling 20-day correlations of several key stock market sectors.  We were compelled to build this model a while back as avid followers of Dr. Brett Steenbarger's work and his outstanding TraderFeed blog.  You can find his more thorough explanation of the indicator here. 

We use this measure along with many others when looking for extremes in the market.  While most of our indicators have yet to flash extreme readings they are getting closer and this chart is no exception.  Below we're observing rolling 20-day sector correlation relative to the S&P 500 since 2012.  As you can see, the current move lower in the market has coincided with a rapid move up in correlations across sectors.  In fact, we've already exceeded the correlation high seen at the mid December lows.  And going back to 2012, when these underlying sectors become highly correlated it has suggested that an intermediate market bottom is in the offing. 



Treating extreme readings like this as potential inflection points has been a wonderful active trading strategy over the last few years.  Simply put: buy weakness and sell strength.  At some point the buy the dip strategy will not work as well as it recently has.  However, with global liquidity still such a force it's possible this can continue on for much longer.  Using these types of measures can be useful when looking for turning points in a reversion market.