Knowing when to get out of a speculative market

We don’t know if portfolio manager Keith Richards gave any advice to Casey and the strawberry blonde he adored, but Mr. Richards recently warned his readers in The MoneyLetter to enjoy the party, but be sure to leave before the music stops. Mr. Casey, alas, danced with the girl with the strawberry curls till his brain was so loaded, it nearly exploded. Don’t try that with your portfolio!

Any technical analyst worth his or her salt will tell you that the breakout through the S&P 500’s May 2015 old high (after 14 months of resistance) of 2135 is bullish. When the Brexit sell-off occurred, we took profits on our hedges and bought a few more stocks on the Monday meltdown following the vote. The recent breakout has justified that move. It added nicely to our portfolio upside in July. We are optimistic and believe that the market will be positive from the fall and on into 2017. However, we continue to retain about 20 per cent cash in our equity platform in light of a greater than average chance of volatility before winter. Here’s why:

Stock market seasonality

Stock market seasonal cycles show that the greatest period of stock market volatility is from late July through to October. Studies by Yale/Jeffery Hirsch (Stock Traders Almanac, published yearly), and Canadian analysts Don Vialoux (www.timingthemarkets) and Brooke Thackray (Thackray’s Investors’ Guides, published yearly) verify this.

Presidential election cycle theory

The end of a second-term president’s run can also add to potential downside. A chart that you can search on stock market seasonal timing website www.equityclock.com, illustrates the standard presidential cycle vs. the second-term presidential cycle. The chart shows us that the potential for loss is greater during the summer in the year of a second-term election. This year could be particularly volatile given the polarity of the candidates.

Option traders’ sentiment

The Chicago Board of Options Exchange put/call ratio chart shows us that the level of puts vs. calls being traded suggests high optimism by options traders. I’ve noted that when the put/call ratio gets to about 0.76 (that is, about 0.76 puts traded for every one call), market players are too optimistic and the market is due to correct.

Chart puts to call

The NYSE Volatility Index (VIX) – another vehicle that tracks the movements of options traders  – is approaching a level that my research shows to be ‘too low’. The VIX measures option premiums, which in a way measure the ‘fear’ premium being built into option prices. When the VIX approaches 12, it has shown to be an accurate indicator of too much investor complacency – and that typically leads to a sell-off.

An interesting phenomenon about the recent rally in markets is that the traditionally “defensive” securities – which are typically sold by market participants in order to reallocate into growth- orientated stocks – are rising along with the growth stocks. In fact, the defensive market sectors – namely precious metals, treasury bonds, and utility stocks – have been making new 52-week highs consistently for more than a year. This has driven these sectors into an overbought state.

I use a rule to tell me if a security is overbought and due for a pullback. This rule will serve you well if you are considering either buying into an uptrend, or finessing an exit. And it’s easy to use. Here’s the rule: If a security is more than 10 per cent over its 200 day Moving Average, it is considered overbought and very likely to experience some sort of pullback.

The defensive sectors noted above (bonds, gold, utilities) are all more than 10 per cent over their 200 day Moving Averages at the time of writing. But that’s not the only sign of irrational exuberance (to quote former Fed Chairman Alan Greenspan) about these securities.

Chart gold hedging

The gold chart shows us that its big picture looks positive given the positive break in trendline and basing action after that break. So too does silver’s chart. In the near-term, gold and silver may be due for a short-term pullback. Not only are they well over their 200 day Moving Averages, but the seasonal period for a bit of weakness in these metals is approaching. According to Thackray’s Investors Guide, it’s typically best to buy gold in late July or early August, and silver is best bought between September and late winter.

Adding to the overbought momentum indicators and seasonality tendencies is the discrepancy between “Smart Money” (commercial hedgers/large position traders) and “Dumb Money” (small speculators /retail) on the precious metals.

The site www.sentimentrader.com shows a condition of exuberance that has not been seen for 23 years. Data going back to 1993, including the 2011 highs on gold, show no comparative for the disproportionate, rampant speculation by small investors. That’s a bit disconcerting. Silver too has had a strong movement lately on the back of retail (“dumb”) money. Ordinary investors are all over this stuff. Like gold, silver is moving at a pace that probably can’t keep going. Don’t get me wrong – the charts for both gold and silver look fantastic. But the momentum oscillators are getting overbought, and retail investors are getting excited about these metals like I haven’t seen since the oil bubble in 2007 and the tech stock bubble in 2000.

For those of us who were trading during either of those times, you may recall that it went REALLY well for quite a while on either of those sectors, and there was plenty of money to be made! But then . . . the music stopped. Thus, my long-term view on bonds, gold and silver is that of playing the trend, and leaving the game before that music stops. That correction may take a while to happen so we might as well enjoy the ride while the music continues to play.

Keith Richards, Portfolio Manager, can be contacted at krichards@valuetrend.ca. He may hold positions in the securities mentioned. Worldsource Securities Inc., sponsoring investment dealer of Keith Richards and member of the Canadian Investor Protection Fund and of the Investment Industry Regulatory Organization of Canada. The information provided is general in nature and does not represent investment advice. It is subject to change without notice and is based on the perspectives and opinions of the writer only and not necessarily those of Worldsource Securities Inc. It may also contain projections or other “forward-looking statements.” There is significant risk that forward looking statements will not prove to be accurate and actual results, performance, or achievements could differ materially from any future results, performance, or achievements that may be expressed or implied by such forward-looking statements and you will not unduly rely on such forward-looking statements. ETFs may have exposure to aggressive investment techniques that include leveraging, which magnify gains and losses and can result in greater volatility in value, and be subject to aggressive investment risk and price volatility risk. ETFs are not guaranteed, their values change frequently, and past performance may not be repeated. Please read the prospectus before investing. Every effort has been made to compile this material from reliable sources; however, no warranty can be made as to its accuracy or completeness. Before acting on any of the above, please consult an appropriate professional regarding your particular circumstance.

 

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