In 1991 Billy and Akaisha Kaderli retired at the age
of 38. Now, into their 3rd decade of this
financially independent lifestyle, they invite you
to take advantage of their wisdom and experience.
On Tuesday, I
posted a series of charts which showed the rather rapid
reversion from more extreme bearishness mid-summer to more
extreme bullishness now.
As I noted:
“But it isn’t just
the more extreme advance of the market over the past
5-weeks which has us a bit concerned in the short-term, but
a series of other indications which typically suggest
short- to intermediate-terms corrections in the market.
Historically, when all of the indicators are suggesting
the market has likely encompassed the majority of its
price advance, a correction to reverse those conditions
is often not far away. Regardless of the timing of that
correction, it is unlikely there is much upside
remaining in the current advance, and taking on
additional equity exposure at these levels will likely
yield a poor result.”
What is quite amazing is that this reversal from “bearish” to “bullish” occurred
precisely as the Fed began pumping liquidity into the
markets. The last time investor sentiment was this bullish
was at the beginning of 2018, which eventually led to a near
20% correction.
As with above, retail investors are “all in” once again with the
smart/dumb money indicator noting an extreme bullish bias of
retail investors.
“With cash levels at the
lowest level since 1997, and equity allocations near the
highest levels since 1999 and 2007, it suggests investors
are now functionally ‘all in.’”
With net exposure to equity risk by individuals at historically
high levels, it suggests two things:
There is little buying
left from individuals to push markets marginally higher,
and;
The stock/cash ratio,
shown below, is at levels normally coincident with more
important market peaks.
Lastly, for a “bullish
sentiment” perspective, investment newsletters are now
exceedingly bullish.
These are all “contrarian” indicators,
which suggest that if everyone is “all
in,” there is currently no one left to “buy.” Such
conditions typically are associated with short-term market
corrections.
However, even if we set aside investor sentiment and positioning
for a moment, the rapid reversion is price has sent our
technical composite overbought/oversold gauge back towards more
extreme levels of overbought conditions.
As noted previously, virtually every measure of volatility has
been suppressed as the “fear
of a correction” has evaporated.
Low volatility measures are a representation of more extreme
levels of investor complacency. Such complacency provides “fuel” for
a reversion as investors sentiment transitions from complacency
to fear.
As we noted just recently for our RIAPRO.NET subscribers, the
divergence of breadth is also indicative of short-term tops in
markets.
What all of this data suggests is that markets have risen “too
fast, too furious” which raises the probability of a price
correction in the short-term.
This is why we have hedged our portfolios last week.
Does that mean we are bearish and betting on the market to
crash.
Not at all.
Why We Hedge
Currently, our portfolios are long-biased meaning we have
more equity-risk in our allocation than fixed income and
cash.
Given the market’s advance, and the data points set out
above, and this
past Tuesday, we have three choices in how we manage our
client portfolios at this juncture:
Do Nothing – if the markets correct, we lose
some of our gains and just have to wait for the
portfolio to recover.
Take Profits – as we have done with extremely
overvalued assets in the past, we can take profits,
raise cash, and reduce our equity exposure in advance of
a correction. Such actions mitigate the damage of the
decline, but positions have to be repurchased, or new
ones added, to resize the portfolio in the future.
Hedge – adding a position to the portfolio that
is the “inverse” of
the market. (the
position goes up in value as the market declines.) This
action allows us to keep our existing positions intact,
and by “shorting
against the portfolio” allows us to effectively
reduce our equity risk (and related capital destruction)
during a market correction.
Why did we choose “Option
3” at this juncture?
Option 1 – is never really a good option. Riding the market
up and down, and spending time “getting
back to even,” doesn’t make a whole lot of sense.
Option 2 – is something that we took advantage of twice this
year already. We took profits at the peak of the market in
May and July before both of the subsequent swoons. We also
added new exposures in early October. So, taking profits
again in some positions would lead to a gross underweight in
certain areas of the portfolio allocation.
This makes Option 3 the most optimal at this stage
of the rally.
With the Fed engaged in pumping liquidity into the markets,
and any day may also include a random market manipulation
from a “Trump tweet,” the
most opportunistic method to hedge risk is to add a “short
S&P 500” index position to the portfolio. The chart
below shows the range of options which we expect could
occur.
Market breaks ABOVE the current upward trending range. We
are currently carrying a stop at 3150 for our short
position, where we will close it out. Yes, we will have a
minimal loss in the position but the rest of our equity
holdings will advance more than making up for the
differential. (Example:
On Friday, the S&P 500 increased .77%, our 60/40 Equity
Portfolio with the Short Position rose by .46%)
Market corrects to the currently rising 50-dma and
in that process reverses the current overbought condition of
the market (top panel, red box) back to oversold. Note: the
50-dma also currently coincides with the previous resistance
of this year’s market highs. A retest of this level that
holds, and removes the overbought condition as noted, would
be very bullish. We will close out the hedge and increase
our long-exposure.
If the market breaks below the 50-dma, and is NOT oversold, the
next level of support is the lower rising trendline. This is
also important support, and a successful test that reverses
the overbought condition would require a removal of hedges.
The last support is the rising 200-dma. If the
market test and holds the 200-dma, is oversold, and
sentiment has returned to a more bearish position, we will
close out our hedges.
IF the market breaks below the 200-dma, we will
likely be discussing the process of reducing long positions
and increasing short-hedges.
Importantly, the range of corrections discussed only runs 3-6%,
which is well within the normal confines of a bullish
correction.
When we discuss hedging against risk, it is invariably taken
that we have sold everything and are now betting on a market “crash.”
Such is hardly the case. We are simply taking prudent actions in
the portfolio management process to reduce capital risk, and
potentially add some incremental “alpha” to
portfolios if a correction occurs.
This is just how we manage risk.
You have a choice to either manage risk, or ignore it.
The only problem is that ignoring risk has a long history of not
working out very well.
The views
expressed by Lance Roberts are not necessarily those of
RetireEarlyLifestyle.com
About the Authors
Billy and Akaisha Kaderli are
recognized retirement experts and internationally published authors on
topics of finance, medical tourism and world travel. With the wealth of
information they share on their award winning website RetireEarlyLifestyle.com,
they have been helping people achieve their own retirement dreams since
1991. They wrote the popular books, The
Adventurer’s Guide to Early Retirement and Your
Retirement Dream IS Possible available on their website
bookstore or
on Amazon.com.
Retire
Early Lifestyle appeals to a different
kind of person – the person who prizes their
independence, values their
time, and who doesn’t want to mindlessly
follow the crowd.
