The Market that Cried “Wolf”

Article Summary:
    • We’re living in the second-longest bull market in history, and it just turned 10 years old in March (the longest was 14 years old before it died: 1987 – 2000).

 

    • For a trend-following model “whipsaws” like the ones that took place in 2010, 2011, 2015, and 2016 cause forced selling on the way down the hill (in an effort to avoid a crash) and buying back into stocks at higher prices (if the market ultimately does not crash), which results in a short-term performance lag.

 

    • Looking back at history, these whipsaws and short-term lagging periods cause investors to become complacent as they lose confidence in a trend-following model, thinking that the market will never crash again.

 

    • This complacency is the exact kind of behavior that creates the euphoria, which ultimately re-kindles the conditions that result in market crashes like the ones we experienced in 2000-02 and 2007-09.

 

    • The current market conditions are healing, but we’re still not out of the woods yet, and it’s entirely too early to get complacent and call 2018-19 another “whipsaw” until more improvement is observed.

 

Just this past month, the current bull market turned 10 years old, second to only the 14-year bull market that culminated in a slow, 2-year death, thanks to the dot-com bubble and tech euphoria that preceded it.  While 10 years is an impressive accomplishment for the market, this bull hasn’t been an easy one to ride!

After the 2007-08 market crash (which resulted in a top-to-bottom decline of -58%), the market had “reset” itself with a little help from multiple stimulus packages in the form of Quantitative Easing (QE) 1, 2, 3, and “Operation Twist.”  Government debt was soaring (and continues to do so), and each time one of the above-mentioned programs ended, the market would struggle and begin to fall.

With each of these drops in stock prices, red flags went up across the board with data suggesting a defensive stance in retirement portfolios and to brace yourself for a potential crash… and each time, the market was either met with another stimulus program, stock buybacks, and/or unexpected, irrational increased demand, which stalled the decline, turning a potential crash into a mere “correction.”

    • In 2010, the stock market fell -16% in only three months, between April – July, which caused most long-term trend-following indicators to trigger sell signals. In the end, the market regained traction after another round of stimulus was injected into the economy.

 

    • In 2011, on the heels of a global downgrade of U.S. government debt (U.S. Treasury debt), the market fell -19% from July thru the bottom, in October. Again, long-term trends were broken and a defensive stance was prudent, but the market received another cortisone shot from Ben Bernanke, which resulted in the biggest October for the S&P500 since The Great Depression.

 

    • In 2015, the market peaked in May and fell -12.5%, but was unable to climb back above the all-time-highs, signaling further trouble on the horizon.

 

    • Then, just months later, through February of 2016, the market fell another -13%, creating panic around the world that perhaps, just maybe this was the big one, but nope… after more than 20-months of sideways market movement with a downward bias, the 2016 election stepped in and for whatever reason, it saved the U.S. stock market, once again.

 

Each one of these periods cause a lag in performance for any trend-following model.  We could write a book and call it “The Market that Cried ‘Wolf,’” since each time the market has appeared it’s on the brink of a crash this past 10 years, something has stepped in to negate these long-term broken trends and turn them around.

Weathering these events takes an immense amount of patience and belief in the long-term success of trend-following.  Just like the book, “The Boy Who Cried Wolf,” time periods like the one we’re living through right now can cause infection and disease in the minds of investors.

Each “whipsaw” creates a lag in performance, tricking the human mind into thinking “This market is just gonna’ keep going up forever.  Why am I even trying to protect against losses, anyway?!”  Complacency becomes the bacteria that eats away at investor patience, and hindsight bias breaks out amongst the investing community.  “I should’ve just stayed put,” they say, when just months earlier, they were panicking about the mere thought of experiencing another Mortgage Crisis (2007-09).

And here’s the sad, but fascinating irony… it’s this hindsight bias, lack of patience, and the complacency effect that ultimately creates the conditions for the next market crash.  The market keeps calling “Wolf,” and eventually, no one listens.

People start experience a serious case of FOMO (Fear of Missing Out), where they want to get in and stay in.  At this point in the cycle, the natural human instinct to protect one’s self has been vaporized by greed and impatience.   Investors take off their armor, and right when they’re kicking back to relax…

So here we are, sitting in the 2nd quarter of 2019, wondering what lies ahead after just experiencing another market drop of -19.8% during the last few months of 2018.  Is this the beginning of the next market crash?  Or is the market going to reclaim its last hurdle, climbing to the ceiling above our heads which represent new highs?

As you can see in the chart below, the above-mentioned all-time-highs lie only 2% above where we currently stand today, while the long-term trend (as measured by the 200-day moving average in rose/pink) is only -4.7% below our feet.  While the quick rise in stock prices this year was impressive thus far, the momentum indicator in the (lower pane of the) chart below suggests the market is still weak and unhealthy, regardless of how good the 1st quarter seemed.

So is this a warning signal suggesting a crash is around the corner, or is this just another whipsaw?  I think the prudent thing to do is to avoid being rigid and binary (i.e. – “on or off”).  We scaled back into stocks, bonds and commodities throughout the 1st quarter in our clients’ portfolios, but we definitely didn’t get in at the bottom, and we definitely aren’t 100% invested right now (we still have some gunpowder left to use, depending on what this market does in the coming weeks).

This leads me to my final point, which is the fact that we don’t have to know what the market is going to do.  We’re trend-followers, not trend-predictors.  So while it may be frustrating to get out of a market on the way down the hill in an aim to avoid a big crash, only to end up paying higher prices to get back in, this is the “cost” of having a tactical, proactive strategy.  The alternative is to put your money into a bunch of different types of investments (regardless of which have the stronger market profile), and leave it alone.  While you might fare well in these short, “whipsaw” periods, the same can’t be said for “the big ones.”

In the 17 ½ years we’ve been in business, our firm has implemented both a Buy & Hold approach (for the first seven years) as well as the patented, tactical, Defense First™ strategy we implement today.  We know the advantages and disadvantages of each philosophy, and while there is no such thing as a perfect strategy, we’ve taken our clients through two market crashes, and while it’s much, much easier to simply “diversify” clients’ portfolios into a bunch of stuff and just leave them alone, it’s not the best thing for the vast majority of serious, long-term investors.

So when I look at the market and how our clients’ portfolios should be invested, I take it day-by-day, week-by-week.  I have no prediction and no opinion on what I “think” the market will do, because the market will do whatever it wants and no one can control it.  The great thing about our strategy is that the market will tell me what to do, and we will react appropriately, regardless of the outcome.

Till next time…

Adam

 

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

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