Asset Re-Balancing To the Rescue?
Asset allocation is nothing fancy. Certain investors, especially Pension Funds, routinely target a specific stock-to-bond ratio for their portfolios, for example 60/40. Since stocks and bonds will have different returns, the portfolio is brought back to its target ratio at the end of each quarter.
If the equity portion of the portfolio LOSES value while the bond portion GAINS, the stock to bond ratio will be LOWER than the target. In order to bring it back to “60/40”, the Fund will have to BUY STOCKS and SELL BONDS. In the quarter just ending, the performance differential between equities (which were down substantially) and bonds was HISTORICALLY WIDE.
According to Wells Fargo, Pension Funds were required to BUY $60 Billion worth of STOCK by the end of this last Quarter and SELL a like amount of BONDS. (https://www.bloomberg.com/news/articles/2018-12-28/one-theory-is-60-billion-pension-frenzy-fed-giant-stock-rebound).
A large stock purchase Program in an already illiquid and volatile market during a HOLIDAY WEEK could certainly create an outsized move.
The Charts on the left for the last three days of last week seems to provide evidence that such a Re-Balancing may have been largely responsible for the magnitude of the move.
The top chart is of the 10 year Treasury Yield. The bottom chart is of the Dow Jones Industrial Average (Dow).
Three Dow “Moon Shots” were simultaneously executed with heavy Bond Sales (producing HIGHER yields). Note that the SIZE of the Programs appeared to diminish each day in magnitude and effect.
Markets Rally Amid Extreme Volatility
Trading during Christmas week through New Years day has always been uneventful. Until now.
Christmas Eve, a half day, was the 6th of 7 days with closing losses exceeding 350 Dow points. On Wednesday morning, the Dow briefly stood at 21,700 before going on a 52 hour tear of 1700 points. The extraordinary volatility is a characteristic of Bear Market Rallies, which usually occur as systemic liquidity worsens. For more background on Bear Market Rallies and how they differ: “Characteristics Of Bear Market Rallies”. (https://markonomics101.com/2018/10/17/characteristics-of-bear-market-rallies/).
All of the key indexes had 3 distinct ramps over 3 days. Below is a Slide Show of the major indexes during their Waterfall Declines of the last 4 weeks to put the rally into perspective.
Some takeaways from these Charts are the following:
- The Nasdaq 100 (NDX) and Dow stopped just below their Resistance Levels of 6,400 and 23,500 respectively. The Standard & Poor’s 500 (SPX) and Russell 2000 (RUT) are still short of these levels.
- None of the major indexes broke substantially above their Declining Trend Channels. Each encountered resistance at the Upper Bounds.
- Each of the Indexes is at a critical point. Further sizable gains would break MAJOR Resistance for the Dow, SPX and NDX and, indicate the conclusion of the Waterfall Decline.
- If the Indexes Break the lower bounds of the VERY SHORT TERM Up Trend Channel from last week, a resumption of the Waterfall Decline would become likely.
Investor Surveys Indicate Extreme Pessimism
Most important market lows occur amid EXTREMELY elevated Fear and Pessimism. Investor sentiment surveys, such as the weekly American Association of Individual Investors (AAII) poll, measure investor mood. Their most recent poll, taken for the week ended December 26, 2018, indicated a LARGE plurality of BEARS (50.3%) to BULLS (31.5%). During the prior week, the number of BEARS was the highest in years. (https://www.aaii.com/sentimentsurvey).
CNN publishes their own Fear/Greed Index. (https://money.cnn.com/data/fear-and-greed/). The index is scaled from 1 to 100, where 1 is the Greatest Fear and 100 the most Greed. The index, currently at 12, reached as low as 2 last week indicating a VERY EXTREME level of Panic.
Unfortunately, this index is not particularly valuable for trading and investing. The index has registered “EXTREME FEAR” for months as the markets declined further.
In late 2016, the index registered “EXTREME GREED” just as the major averages took off on substantial rallies.
..But Not The Volatility Index (VIX)
The Volatility Index or VIX is a market measure of investor Fear or Complacency. The VIX is a measure of investors’ expectations of the prospective variability or uncertainty of future returns. A HIGHER VIX correlates with greater FEAR among investors.
Volatility is the single most important factor in determining how expensive hedging a portfolio or stock will be through the use of options. One can think of it as analogous to an insurance premium. The higher the PERCEPTION of risk of an adverse event, the higher the premium to “insure” against that event.
The highest level reached by the VIX last week was 36. It ended the week at a much reduced 28. Was THE PEAK reading of 36 indicative of the level of Fear generally required to coincide with a REAL bottom?
The chart below, which compares levels in the Dow with levels in the VIX for the last 20 years, would suggest NO. For one thing, readings of 36 or above are not that uncommon. Depending on how one counts the incidences, there have been a dozen. Some have lasted MONTHS.
Readings above 45 have occurred 7 times and have been indicative of solid lows much more often than not. But even the 90 VIX recorded in the chaotic Waterfall Decline during October, 2008 did NOT mark THE Bottom of the 2008-9 Financial Panic. The bottom occurred months later.
The other missing ingredient is heavy volume, at least 2 to 3 times average daily. During the Waterfall Decline, SPX Volume barely rose and actually DECREASED during the 3 day rally. That’s one of the problems with polls and surveys. It’s behavior that counts. The implication is that all these BEARISH investors have yet to sell.
Is The Mini-Bear Over?
It probably isn’t, but, for the moment it still pays to AVOID taking on or holding onto too much risk. Sometimes the best strategy is Preservation of Capital. The environment for investing in ANYTHING is problematic. Almost NO asset classes, except very short term high grade Bonds, are producing positive returns. A beginning guide to reducing risk can be accessed here: “How to Survive, Prosper and Thrive in the Coming Bear Market”. (https://markonomics101.com/2018/10/09/how-to-survive-prosper-and-thrive-in-the-coming-bear-market-part-1/).
Deutsche Bank has been collecting annualized return data on assets going back to 1901. This year, has been the WORST on Record with 93% delivering NEGATIVE RETURNS. The prior record was 84%, established in 1920. (https://www.zerohedge.com/news/2018-12-21/2018-officially-worst-year-record-93-all-assets-down).
Sitting on the sidelines, as we’ve been recommending for MONTHS, has been the right strategy for 2018 and into early 2019. The best opportunities arise when most are desperate for liquidity. That’s when bargains can be had.
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