A Different Kind of Crash

Financial Advisor

 

My plans were to write this week’s commentary on Sunday night, since the Dow had already fallen more than 1,200 points in August, while dropping over 1,000 points last week, alone. I’m glad I decided to go on a walk with Donna instead. There’s much more to talk about now that Monday is over with.

Important Note: Also, I want to make note of the fact that this week’s commentary is going to be aimed more at informing our current clients than keeping the public abreast of the market and economic changes occurring today. Normally, I write in generalities, but considering the huge swings we’ve seen and the accompanying fear those swings have created, I wanted to make sure I put something together today that:

  1. Let our clients know where they are today from an allocation and protection standpoint, and
  2. Keep our current clients from worrying about what may lie ahead.

The VIX, which measures market volatility, soared to a 7-year high today. Said another way, the market hasn’t been this volatile since the end of The Great Recession. Tesla (TSLA) has dropped -22% since its recent high in July, Netflix (NFLX) has fallen -30% since peaking in August and even everyone’s darling stock, Apple, couldn’t manage to hold its positive (PnF) trend, which is only the third such occurrence in a decade, the most recent being back in early 2013.

When performing a strength comparison between bonds and stocks (using the AGG and SPX), bonds have started gaining momentum for the first time since 2012. As the trend moves downward in the chart below, it shows us that the long-term trend is one of bonds being weak vs. the S&P500 (U.S. stocks). However, that trend has started to flatten as of late with a recent spike in strength for bonds this past few trading days.

AGG vs SPX Aug 24 2015

 

In similar fashion, I ran a strength comparison between the S&P500 and its inverse, the SH (Short S&P500). The current champion (owning the S&P500) is starting to look tired, losing momentum and strength vs. its inverse (i.e. – “shorting” the S&P500). The change in leadership is becoming more probable now than before and technical indicators are confirming such a probability. All jargon aside, in the end, the story is the same – shorting the market, while not yet advisable, is starting to look like a future, near-term possibility. Not a probability – but completely and totally possible.

SPX vs SH RS Chart

Remember, I’m not a trend predictor – I’m a trend follower. No one can predict trends and trends take time to develop. Contrary to what most investors think, corrections and crashes don’t occur over night. Even Black Monday in 1987 had a little warning in advance (although I’ll admit – not much).

Since March, the S&P500 has struggled to make new highs and broke into a negative trend twice. The Dow has been even worse off, breaking into a negative trend and logging YTD losses on the year well before the S&P500. The percentage of stocks on a PnF (Point & Figure) buy signal has been trending down since 2013 and the percentage of stocks in the U.S. that sit on a positive trend has been falling consistently since July.

As more and more investments started leaving the battlefield (i.e. – breaking their trend lines and walking home), I began selling investments out of our client’s portfolios – and this began back in May. It started small and infrequent, but whenever a trend failed or an investment fell through my trailing stop loss, I’d sell it and just let the proceeds sit in a money market account.

It all started with the selling of our last airline stock we owned. From there, international investments started to break down and I sold out of Russia, the Philippines, and China, but left a couple broad international indices in our models. Next, I sold a couple more stocks in June, then a bond position or two as treasury bonds began to weaken… but the real acceleration started in July. By the end of July, our portfolios were sitting in anywhere from 20-40% bonds and “cash” (money market equivalents), depending on the model in question.

Last week, we sold one stock in our aggressive portfolio (the Libertas model) on Wednesday, which left our portfolios looking like this:

Model Portfolios on Aug 19

*Portfolio Models as of market close on 8/19/2015. Model portfolios are displayed from left-to-right, ranked most aggressive to most conservative.

On Friday morning, I pulled the ripcord on quite a few investments, including the remaining two international positions we owned, leaving us with a 30-66% cash/bond position (again, depending on the portfolio in question).

Model Portfolios on Aug 21

*Portfolio Models as of 12:30pm on 8/21/2015. Model portfolios are displayed from left-to-right, ranked most aggressive to most conservative.

 Then Monday got really interesting. Not only did the Dow open and crash to the tune of -1,000 points in the first six minutes, but the losses got so bad that the NASDAQ halted trading, keeping any investor from trading any NASDAQ-listed investments!

You see, when “The Flash Crash” occurred back in March of 2010, the initial tipping point was something called a “Fat Finger Trade,” where a financial advisor accidentally put an extra zero at the end of his share quantity, effectively selling 1,000,000 shares instead of just 100,000. The huge, accidental trade caused the market to panic, wondering what was wrong with the company’s stock, which then turned into an overall market selling frenzy, which in turn triggered a ton of open stop-loss orders as the markets continued to fall.

Nerds note: Open stop-loss orders are sell orders that are keyed the market ahead of time in order to “protect” an investment from losing money. Because the market was falling so fast that day in March, all these stop-losses triggered, sending the market down further and faster than it would’ve gone otherwise, without any stop losses in place.

That day five years ago didn’t feel all that much different than Monday, but what caused the market to crash so quickly this time was “real” market action – real sellers hitting the “sell” button and getting out… and fast. This makes this a different kind of crash than we saw back in March of 2010. People were actually paying attention and intentionally selling into the panic.

With that all said, the Dow managed to cut away at its losses as noon approached. At one point, it was only down about -102 points (talk about wild swings)! From 11:50am through 1:01pm, we pared back the bulk of what we sold Monday, leaving us with anywhere between 72-80% bonds and cash equivalents, depending on the model in question.

Model Portfolios at Close of Aug 24 2015

*Portfolio Models as of 12:30pm on 8/24/2015. Model portfolios are displayed from left-to-right, ranked most aggressive to most conservative.

 While this might seem extreme to some, all I’m doing is following a rules-based process that we’ve built in order to keep the emotions out of our buying and selling decisions. When we buy something, we know that we want to sell out nowhere lower than -5-20% from where we buy it. As the investments move up in value, we ideally want to sell those growing investments for no less than approximately -10% off their recent high. As each investment breaks down, we open the trap door and let it go. No tears, no good-bye’s, and no divorce paperwork. Just clean, quick, disciplined defense.

None of this means a crash is around the corner, by the way. After all, looking at the futures market today, those of us with a really short-term memory will think that the worst of it is over! Ahhhh… short-term memories. How they often deceive us.

I had one client call us wanting to sell everything before the market opened Monday. This would’ve caused this person’s portfolio to sell at prices just after the open – which would’ve been the absolute worst time to sell in four years! I convinced them otherwise, of course, but I suppose this same recency bias might have them thinking today that maybe they should go “all in!” Meh…

I’ve been saying the same things over and over again – to our clients in-person, speaking at events, in our Halftime Report update video, on our podcast, and in this commentary – that:

  1. We’re smack dab in the middle of the seasonally weak months of the year for the U.S. stock market
  2. September is historically the worst month of the year for the market with October not far behind (…and August is supposed to be a light month!)
  3. September and October have recorded especially weak returns in the 7th year of a two-term election cycle, and
  4. While the market averages one, -10% (or worse) correction per year since the beginning of time, we haven’t seen a single correction in more than four years!

Every day that passes is one more day closer to a correction. We can’t sell out AT the top and we can’t buy back in AT the bottom. We feel that our job is to protect our clients from as much portfolio loss as humanly possible while participating is as many gains as we can, all while keeping market and economic risk in mind.

When risk levels are low, we put the offense on the field and try to score points as conservatively as possible. However, when market landscape exhibits risk levels that are high, we throw the big dogs on the field, firm our stance, and play some good defense.

If you have ANY questions at all, please contact our office via email or phone. You do NOT have to be a client to ask a question.

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If you have any questions regarding portfolio management, estate planning, or financial planning, please contact us so that we can confidentially discuss you or your company’s situation further.

Till next time,

Adam

 

returns 8 24

 

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Disclosures: All index returns are rounded to the nearest tenth percent. All data above sourced via Yahoo! Finance. The proxy used for international investments is the ACWX (all country world index ex-US). The proxy used for commodities is the DBC (PowerShares commodities index). Past performance is no guarantee of future results. Indices are unmanaged and cannot be invested into directly.

 

The opinions mentioned in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. Past performance is not guarantee of future results. Economic forecasts set forth may not develop as predicted. The views and opinions expressed in this commentary are those of Adam Koos and do not necessarily represent the views of TD Ameritrade and its affiliates. Investing involves risk including loss of principal.

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

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