Bull’s Maginot Line
“The Maginot Line, named after the French Minister of War André Maginot, was a line of concrete fortifications, obstacles, and weapon installations built by France in the 1930s to deter invasion by Germany and force them to move around the fortifications. The Maginot Line was impervious to most forms of attack, including aerial bombings and tank fire, and had underground railways as a backup.” – Wikipedia
For the market, the bulls are currently testing the respective “Maginot Line” going back to February of this year.
While the longer-term sell signal remains intact currently, the market has now risen enough to test the last line of resistance standing between the “bulls” and a charge to this year’s highs. With the Nasdaq hitting all-time highs on Thursday, it is now quite likely traders will try to also push the S&P 500 to new highs as well.
However, as of now, the market stands at a critical juncture. As we laid out a couple of week’s ago, it continues to be a “battle of wills” between the bulls and bears. A break above current resistance will bring Pathway #1 into focus as a push to previous highs becomes a very high probability event. If, however, the market fails to move higher, then Pathway #2 will suggest a retest of recent support at the 50-dma which has now also turned positive. The cluster of support which has gathered around the 100-dma reduces, but doesn’t eliminate, the probabilities of a larger drawdown in the short-term.
As I stated previously, these “pathways” are not predictions. The analysis is used to make some “assumptions”about where the markets will likely head given the various risks we are currently weighing in our portfolio allocation models.
Those risks include:
Tweets from the White House (who would have ever thought such would be a risk)
You get the idea.
For now, the risk of a bigger correction has been somewhat mitigated particularly as we move deeper into earnings season. Earnings should be somewhat supportive to the bulls as once again, miraculously, there will be a high “beat rate” of earnings estimates. Of course, this is always the case as estimates are lowered prior to entering earnings season so the bar is set low enough to achieve “beat rates.”
In just the last two months, estimates have been lowered sharply. The reality is that if analysts were required to stick to their initial estimates; 1) roughly all companies would fail to exceed their goals, and; 2) Wall Street would be much more prudent, and honest, about their estimates.
But, while that is a philosophical argument, the reality is that we must also “play the game,” and lowered earnings estimates will make “earnings season” more supportive for the bulls.
The “risk” will be the “forward guidance” as companies start talking about the risk to higher commodity prices, a strong dollar, and tariffs. The chart makes an adjustment to account for the risk of a trade war which could effectively eliminate the benefit of the “tax cut” boost entirely.
On a weekly basis, the bull’s “Maginot line” becomes clearer.
A couple of weeks ago, I “jumped the gun” and assumed that a weekly “buy” signal was about to be triggered. I quickly relearned my lesson to wit:
“I made a mistake. It happens.
While we strictly adhere to our discipline, sometimes we have to relearn lessons the hard way.
‘Last week, I wrote:
However, if you are so inclined, the pullback to support last week does provide an opportunity to increase exposure modestly. (I said modestly, not ‘jump in with both feet.’)’
That was a mistake as I was ‘anticipating’ a reversal of the ‘sell signal.’ ‘Anticipation’ is an emotion and has no place in portfolio management.
Lesson learned, once again.”
Of course, it is hard to believe that just a few weeks ago we were sitting basically where we are today. With the markets rallying, bullish optimism rising, and the market close to registering a “buy signal,” this time looks a whole lot like “last time.” However, the question is now whether the bulls can succeed where they failed previously.
Next week, either the bulls will breach the “Maginot Line” and claim “victory,” or they will be repelled back to defensive positions.
Currently, based on the very short-term risk/reward analysis, we find the bulls have the edge. With our portfolios are already mostly exposed to equity risk, there isn’t much for us to do expect to wait for a confirmed break higher to begin moving portfolios back to full target allocation weightings.
Ryan Vlastelica had an interesting post at MarketWatch last week discussing the long “correction” periods. To wit:
“Amid months of rangebound trading, neither index has been able to fully recover and notch new records, which is what would be needed for them to exit correction territory.
Including Friday, both the Dow and the S&P have been in correction territory for 108 trading days. This matches the longest such stretch since the financial crisis in 2008.
Should the two primary market gauges stay in correction through the close of trading on Monday, that will mean they are in their longest such stretch since 1984. In that stretch, it took the S&P 122 days to emerge from correction territory, and the Dow 123 days, according to the WSJ Market Data Group.”
“Despite the bearish record that could be set on Monday, the market is also nearing a more positive milestone. On a total-return basis, the S&P 500 is just days away from its longest stretch above its 200-day moving average in its history.”
There are two very important takeaways from this article.
The first is that long-corrective periods tend to ultimately resolve themselves relative to the level of valuations.
- The long corrective period that ended in 1984 was just coming out of the 1974 crash and two back to back recessions. Valuations were extremely depressed at the time and inflation and interest rates were high and falling.
- The next series of corrections that started in 1998 were early warning signs to a market frenzy but the bigger corrective period preceded the “dot.com” crash. Valuations were elevated and rates and fears of inflationary pressures were rising.
- The next corrective periods were near the 2003-2004 lows of the market as the markets begin to consolidate the bear market bottom. Valuations had fallen markedly, rates and inflation were falling, and excesses had been wrung out of the markets.
- Following the credit-driven rise in the market from 2004-2007, the market once again began a long consolidation period which marked the top of the bull market cycle. Once again, rates and fears of inflationary pressures were rising, the Fed was tightening monetary policy, and valuations were elevated.
Where are we today?
Are valuations low with rates and inflationary pressures falling? Or, is it the opposite?
The second point from Ryan was noting the S&P 500 is about to achieve its longest, total-return, run in its history.
- What happened the last time such an incredible feat was achieved?
It is worth remembering that “records are records for a reason.”
Records are never achieved at the beginning of a cycle.
Momentum Is The Last Stage Of The Investment Cycle
While our short and intermediate-term views are more bullishly biased, we are most definitely long-term bears. Ryan’s data points above further support that view.
The laws of physics apply to the markets just like everything else in life. Trying to deny those laws is akin to saying “gravity doesn’t exist.”
Currently, there is little doubt that we are in both the late stages of an economic cycle and a momentum-driven market. Breadth has narrowed substantially, valuations are elevated, rates and inflationary pressures are rising, and price deviations and overbought conditions are at extremes.
From an investment standpoint, we must maintain an investment focus which is adjusted to current market dynamics. As stated, given we are in a “momentum” market, we must adopt strategies that incorporate relative strength and momentum based measures. The chart below shows the overlay between market and economic cycles and investing strategies.
Momentum cycles are the “last phase” of an investment/market cycle. Eventually, momentum will give way to a “mean reversion” process at which point our focus will switch to a valuation-based strategy.
But this is the risk that most investors are overlooking currently as individuals chase“hot stocks.” The belief is that if they have doubled once, they will double again.
In the short-term, this is not entirely wrong. There have been many studies published that have shown that relative strength momentum strategies, in which as assets’ performance relative to its peers predicts its future relative performance, work well on both an absolute or time series basis. Historically, past returns (over the previous 12 months) have been a good predictor of future results. This is the basic application of Newton’s Law Of Inertia, that states “an object in motion tends to remain in motion unless acted upon by an unbalanced force.”
In other words, when markets begin strongly trending in one direction, that direction will continue until an “unbalanced” force stops it. Momentum strategies, which are trend following strategies by nature, have been proven to work well across extreme market environments, multiple asset classes and over historical time frames.
While there is substantial evidence that market valuations and fundamentals are not supportive of asset prices at current levels, the “momentum chase” can keep markets “irrational longer than logic would dictate.”
But, not indefinitely.
The problem for solely “fundamentally based” investors is they tend to be slow to react to new information (they anchor), which initially leads to under-reaction but eventually shifts to over-reaction during late cycle stages.
The other inherent problem of primarily data-based investors is the “herding” effect.
As prices move higher, valuation arguments lose relevance. However, the need to produce investment performance in a rising market, leads to “justifications” to explain over-valued holdings. In other words, buying begets more buying.
Lastly, as the markets turn, the “disposition” effect takes hold and winners are sold to protect gains, but losers are held in the hopes of better prices later. The end effect is not a pretty one.
Understanding these issues is why we apply momentum strategies to fundamentally derived investment portfolios. This allows the portfolio to remain allocated during rising markets while managing the inherent risk of behavioral dynamics.
While we discuss the risk of investing as it relates to the destruction of both “capital” and “time,” our portfolio models have remained “bullishly” allocated during the market’s advance. But such will change when the markets change.
Our job as investors is to make money when markets are rising during the first half of an investment cycle, and avoid potentially catastrophic losses during the second half.
For now, the markets are rising, and we need to participate until the trends change. Of course, if your current portfolio management philosophy doesn’t have a method to understand when “trends” have changed, how will you know when it is time to step away from the poker table?
To paraphrase Kenny Rogers:
“As every good investor knows…you gotta’ know when to hold’em, know when to fold’em.”
Go to Source
Author: Tyler Durden