A New Month, A New Market?

While I try to write one of these updates on the state of the market each and every week, it’s the end (or beginning) of a month that adds some good perspective. Reason being, we always want to invest with the trend, not against it. And for most investors, the trend they’re trying to invest with is the long-term trend, and one way to define the long-term trend is by looking at monthly charts. The problem with monthly charts is that they’re only valid at the end of each month, but this is what makes them so insightful. They are truly “long-term” in nature, so let’s take a look at what the market looks like now that February is behind us.

When I evaluate the prevailing risk vs. reward landscape of the markets, I take a “weight-of-the-evidence” approach to determining whether to invest in something and how heavy our allocation should be. I always describe this as a “dimmer switch” (as opposed to an “on/off switch”). In other words, there is no single tool, indicator, or signal that I watch and “if this or that happens, then we sell everything… and if this or that happens, we go all-in.” It doesn’t work that way, nor it shouldn’t.

Rather, when the probability of reward is favorable, relative to the amount of risk apparent in the market, then we can “turn up the dimmer switch.” However, as the amount of risk increases, relative to our probability of making money in the markets, we “turn down the dimmer switch” effectively moving money to safer places (such as money market or bonds, all depending on their relative strength relationship, but let’s keep this simple)…

In summary, it’s impossible to get out of the market at the top and jump back in at the bottom. For instance, the market peaked on Sept 21st and after a swift decline in late-Sept/early-Oct, we started “turning down the dimmer switch” and protecting the capital in our portfolios. We didn’t get out all at once, and we never will – but over the course of eight weeks, we went from being 95% invested, to 70%, to 50%, to 30%, and eventually, we were sitting on the sidelines by mid-Dec.

While the market continued to decline afterward, culminating in the big Christmas Eve drop, since then, stocks have moved upward impressively over the course of the last 44 days.

Now… this is where investor psychology becomes an issue. Humans are impatient mammals and suffer from a severe case of FOMO (Fear Of Missing Out).

* Did you know that the market “bounced” to the tune of +11.2%, +12.0%, and +7.4%, all while it declined a total of -58% throughout 2007-09?

* Did you know that the market “bounced” to the tune of +7.8%, +8.6%, +18.8%, +21.3%, and +20.4%, all while it declined a total of -47% throughout 2000-02?

The point here is that the market can rise in the short-term, making it FEEL like you’re missing out on the long-term… but it’s the plight of human behavioral psychology that causes us to make the worst decisions at the worst times. Humans want it all – they want all the upside gains and none of the risk. The problem here is, this just simply doesn’t exist.

Nevertheless, as the risk/reward profile has changed over the course of the last two months, we have metaphorically “dipped our toes” into the market and invested a small percentage in stocks, as well as adding a couple investments in oil and gold. So again, we’re allocating our clients’ portfolios according to the risk/reward profile of the market.

Let’s take a look at just a few of the pieces of evidence I’m paying attention to…

In the chart below, each candlestick represents one full month. This means that it’s a very, very long-term chart and thus, one of the many, big pieces of evidence I put a lot of weight upon. Just for educational purposes, know that every black candlestick is a down month (think black = filled with lead = heavy = down) while every white candlestick is an up month (think white = empty & filled with air = light = up).

The red, down-arrows indicate each time the market fell below its 10-month trend (moving average), and the blue, up-arrows are each time it rose back above this level. I’m only showing you the last 12 years or so, just to keep things simple here. But you can see how:

1. These signals are infrequent and thus, must be given serious consideration.

2. Sometimes they cause “whipsaws,” which mean we’re selling low and having to buy higher to get back in – this is the cost of managing risk and avoiding market crashes.

3. 2015-16 handed us two whipsaws-in-a-row, all while the market went nowhere for almost two full years (this is frustrating, but part of being an investor).

4. Most recently, the market just moved back above the 10-month trend on Thursday of this past week, which is a positive development in the “evidence” that this market may reverse its trend and head higher from here in the long-term.

I’ve received a ton of positive feedback over the last few months about the next chart. Granted, my fellow market technicians probably hate how elementary it is… but the

“average” investor, from my experience thus far, seems to feel that it makes things very simple and easy-to-understand.

1. The red, shaded area is where I’d consider the market to be in a clear, avoidable downtrend and its managed to rise back above that level for the time being.

2. The yellow area is where I’d consider the market to be “trendless,” and in a state of transition. From where we sit today, we’re either going to head higher, or the market is going to move back into the red area and continue its downtrend.

3. The green, shaded area represents the first, new, intermediate-term “higher-high” (above the highs from Oct/Nov 2018) and for me, it would indicate that the market could be reversing up into a new, potentially sustainable uptrend. It is also where I’d be interested in putting a lot more investable money to work.

4. What concerns me on this chart, however, is that momentum (in the lower pane) has made a couple trips below 30 (which is unhealthy), and even after this big bounce off the Dec 24th lows, it has really struggled to get above the “healthy,” bullish 70-level. This piece of evidence confirms the cautionary stance I’m currently taking.

This is the same chart as above, but I’ve just changed the perspective a bit to drive home a couple points:

* The market has “topped out” at around 2,820 on the S&P500 four times now, and the more times an investment fails to move above (or below) a line in the sand such as this, the stronger that line becomes. It’s also why we want to exercise caution below this level and not get too heavily invested in stocks.

* Again, while the rally off the Dec 24th lows has been impressive, the momentum behind the move has not. This, again, does not add to the positive evidence for this market and suggests possibility of a drop in value before we see new highs.

Here’s my last chart of the day, but one that I always refer back to when looking at the big picture. Without getting into the nitty-gritty, nerdy details, the blue, up-arrows and red, down-arrows are buy and sell signals using an ultra-long-term momentum indicator that I follow (called the Price Momentum Oscillator). As you can clearly see:

* There have been five, blue “buy signals” and five, red “sell signals.”

* All five of the buy signals have been valid and resulted in solid market gains.

* 2 of the five sell signals turned out to be invalid (whipsaws) where the market reversed back up again without crashing (in 1998 for just a few months, and in 2015-16, when the market grinded sideways with a downward bias for a frustrating, 20+ month period of time).

* However, 2 of the five sell signals also assisted in the avoidance of two, catastrophic market crashes (-47% in 2000-02 and -58% in 2007-09).

* The fifth sell signal that took place in November (just three months ago) is still up for debate, and we won’t know how this ends until it’s well behind us. What we do know is that it’ll either end up like one of the market crashes – or one of the whipsaws – and leaving all your money in the market (to chance), diversified or not, is not a “strategy.” After all, U.S. stocks, international stocks, commodities and bonds all lost money in 2018, so diversification doesn’t do much for you when everything is falling in value.

The chart above represents 24 years and only five sell signals. Again, we’d never want to use just one signal or indicator as our ONLY method of risk management. However, if you think of this as a retirement savings tornado siren, it probably makes sense to take your family to the basement vs. “waiting it out,” considering the amount of risk that’s at stake.

With another month in the books, it’ll be interesting to see how the next few weeks play out. The market has shifted from “negative” to “neutral,” but to use a casino analogy where the up = black and down = red, this “neutral” state doesn’t mean investors should put all their money on black.

Anticipating what the market is going to do is a losing battle. Rather, investors should analyze and observe the markets, dial up the risk incrementally as the risk/reward profile improves, dial it back down as probabilities of gains decline, and of course, invest with the trend, not against it.

Oh, and patience… yes, patience is key! Don’t allow yourself to suffer from FOMO. Your retirement portfolio won’t like you for it! One of my mentors once said to me, “Whenever you feel the sudden urgency to make a decision, typically in those situations, whatever they are, the best decision instead is to do nothing at all.”

Till next time…

Adam

Categories: Adam Koos, CFP®,CMT®, Market Commentary

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