Danger on the Horizon

Financial Advisor

As we work our way through the summer doldrums, we also find ourselves walking directly into the statistically worst months of the year for the stock market. While the S&P500 is up just over 1% year-to-date, the Dow Jones Industrial Average has seen better days, down -2.66% as of today (Wednesday, August 19th).

There are a lot of indicators I follow when observing the markets. I like to say that it’s a lot like an orchestra; just because the trumpets are playing out of tune doesn’t mean you fire the whole symphony. It’s also similar to a doctor’s patient being set up on an EKG, blood pressure, and heart rate monitors. Just because we see a reduction in the patient’s heart rate doesn’t mean we need to get the defibrillator out and shock the crap out of them!

With all that said, let’s take a look at the metaphorical “patient” and see how the market’s vital signs look today.

First off, the percentage of stocks on the NYSE (New York Stock Exchange) – so U.S. Stocks – trading on a buy signal (higher high) has been trending down over the last couple years. We’ve seen lower highs and lower lows over time, and more recently, we’ve seen a weakening on the chart, which indicates the need to take a more defensive stance toward stock exposure.

We haven’t quite seen a number lower than what we observed back in October of last year, but in 2008, only 4% of NYSE stocks were trading on a buy signal (said another way, 96% of stocks were on a sell signal – or “lower low!”).

NYSEBP annotated

The next indicator we’ll take a look at is something called a Percentage Trend chart. This time, we’re looking at a Point & Figure (PnF) chart, which is why you see X’s and O’s as opposed to a line chart.

A Percentage Trend (or PT chart for short) measures the percentage of stocks trading in a positive trend on their PnF chart. In a healthy market, this chart is above 50%, which means that more than half of the stocks are trading in a positive trend. When the chart reverses down (into O’s), however, this means that the percentage of stocks on a positive trend is declining or weakening. As you can see in the chart below (and again, we’re looking at U.S. stocks on the NYSE), not only are we seeing a weakening in the PT chart, but as of today, we’re less than a half-point away from moving below 50%, which would indicate further defensive posture.

NYSEPT annotated

The next chart we’ll look at is called a High/Low index (or Hi/Lo for short). A Hi/Lo chart is a participation (or breadth) indicator, which tells us how many investments are participating in the current trend.

<Nerd’s Note: The chart is calculated by taking the total number of new, 52-week highs, and dividing that number by the total of both 52-week highs and 52-week lows. It is then plotted on a chart like the one you see below>

When the Hi/Lo index is increasing, it tells us that there are a lot of investments participating in the current trend. When it’s declining (like it is below), it means that fewer and fewer investments are participating in the up-swing, which indicates further weakness in the market. Again, I’m looking at the NYSE here, so when you look at this chart below, it’s telling us that while U.S. stocks are still very strong, relative to other investment categories, fewer and fewer stocks in the U.S. stock market are pulling the weight of the overall trend.

NYSE HiLo annotated

The silver lining can be found in one of my comments in the previous paragraph. When you look the markets from a 30,000-foot view, we can sum up the entire investment landscape in six investment categories (listed below). While we’ve seen the Dow break down and the S&P500 struggle to find northward traction, on a relative basis (relative to other investment categories), U.S. stocks still sit solidly in pole position at the head of the pack with no signs of wavering just yet.

There has been some asset class rotation amongst the lower-ranked investment categories. International Stocks and Fixed Income (bonds) have danced back and forth between #2 and #3 twice in 2015. Further, it has been extremely difficult to find investments in either of these second-tier categories that can give us positive returns. For instance, the U.S. Bond Market (as represented by the Barclays Aggregate Bond Index – AGG) is still down year-to-date, -0.65%… and we thought bonds were “safe?”

While “Cash” (or money market equivalents) have been picking up steam and moving up in rank, all the steam is being stolen from international stocks and bonds… not U.S. Stocks. This just goes to show, A) How strong U.S. Stocks remain at this point in time, and B) That any attempt to diversify away from U.S. stocks has only created lower performance in your portfolios.

Asset Class Ranking

I continue to focus our portfolios on the top-three ranked investment categories listed above in our Asset Class Ranking System, as we have in the past. It goes without saying that we generally avoid the bottom three-ranked investment categories, however, this past couple months, I’ve trimmed some of the already-small international investments we owned, taking a more defensive stance toward international stocks. The same can be said for bonds, an investment category from which it has been borderline impossible to create any growth in 2015.

Every time I buy an investment in our portfolios, I always know where I want to sell it before we even add money to the investment in question. I call this my “trapeze net,” which represents the point at which I’m no longer willing to hold the investment and leave the risk on the table. As an investment rises, pulls back, and rises again to new highs, I raise this “trapeze net” on an ongoing basis until eventually, the point at which we’d sell is one that would be a guaranteed profit (Nerd’s Note: This is called a “stop loss”).

In today’s market, as we entered the seasonally weak months of the year in May, and as we’ve seen the indicators we’ve gone through (above) today start to break down, I’ve started to raise these trapeze nets to more conservative levels so that my exit strategy is implemented earlier than usual. As a result, our portfolios have seen an increase in cash levels over the last few months. As each investment has broken down in momentum, strength, trend, or all three, I generally haven’t purchased anything in place of the investments we’ve sold.

Current Libertas SR Model Allocations

The concept of raising trapeze nets, raising cash levels, and taking investments off the table is to decrease the risk levels in our portfolios. As an example, our aggressive portfolio has 44% of its value currently sitting in money market equivalents, which means we’re taking roughly 44% less risk than “the stock market” in that particular portfolio.

In our Moderate portfolio (The Liberty Portfolio), 25% of our money is on the sidelines, which means we’re taking 25% less risk than the market. Wait a minute? There’s more cash in the Libertas portfolio than there is in the moderate Liberty portfolio? What’s going on here?

The smaller percentage of cash in the Liberty portfolio is a result of the kind of investments we own inside the model. The Liberty portfolio, when invested in U.S. stocks, is invested in 50% ETF’s (Exchange Traded Funds – or “baskets” of stocks) and 40% individual stocks. The Libertas portfolio, on the other hand, is invested in 100% individual stocks.

Think of ETF’s (baskets of stocks) like big yachts. When they move up and down; when they change directions, it takes a little more time to round the corner and break down. Conversely, individual stocks are like speedboats. They tend to move faster and thus, provide more frequent opportunities to implement an exit strategy.

Yachtspeed-boat

As the third quarter continues to progress, feel free to contact our office with any questions about the market, economy, China, Greece, the Yuan, or anything else that’s concerning you. We’re here to explain these complicated matters in easier ways than what is written above. Everyone is different, but most of the investing public doesn’t understand this stuff. If you want to know, we want to teach you.

If you know someone who would like to be added to our mailing lists for market commentary, educational articles, and invitations to our events (both social and educational workshops), please forward this email to them, or reply with their name and email address so that they don’t miss out on any future events and/or educational opportunities!

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

Our office is an Adopt-a-Platoon “parent” for US troops overseas and we send a care package overseas to an active-duty G.I. once each month. If you plan on coming into the office soon, please remember that you’re welcome to bring any items along with you for the gift package. If you’d like to see our current G.I.’s wish list, reply to this email with a request for it and we’ll forward it to you right away. Thank you, in advance, for your support of our military personnel!

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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