Time for some spring cleaning of your investment strategy

Nature is springing back to life. But the markets are likely to correct significantly. Rebalance to emphasize cash and low-beta stocks. Keith Richards, portfolio manager at Barrie, Ont.-based ValueTrend suggests some exchange traded funds as part of an investment strategy to let you enjoy the summer.

For most of us, spring is the time of the year for new growth. Flowers begin to blossom and lawns start to turn from brown to green again. Spring showers wash the sand and salt from the roads, allowing joggers, cyclists, motorcyclists and sports car drivers to come out of hiding. Yes, spring is a time of renewed optimism and positive energy after the long, harsh winter.

The markets are seasonal too

Spring does not usually lead into a period of growth for stock investors, however. Markets often form short-termed peaks in April or May, leading into corrections or slower growth markets that continue into the summer or fall.

The S&P 500 composite index has shown underperformance from May through November about 70 per cent of the time since 1950, according to Thackray’s Investor’s Guide. In Canada, the S&P/TSX composite index has underperformed similarly in most years.

Spring cleaning your investment strategy

For this reason, and other bearish signals noted below, our investment strategy has been to pare our way out of high-beta equities, a little at a time, over the past month. (A stock with a beta of 1.0 moves exactly in line with the benchmark index—neither more volatile, nor less. A stock with a beta above 1.0 is more volatile than the market.)

Clouds on horizon—in the shape of a market correction

Below are several pieces of evidence that point to a potential summer/fall correction.

■ The cyclically adjusted price-to-earnings ratio—commonly known as “CAPE” or, alternatively, as the “Shiller P/E”—is flashing a warning sign. CAPE is defined as price divided by the average of 10 years of earnings, adjusted for inflation. It is currently at more than 26 times the S&P 500’s trailing earnings; historically, this is a level that has preceded market corrections.

■ The U.S. dollar has become overbought in the face of its sole leadership in global economic growth. Eventually, this runaway train has to stop. The U.S. Federal Reserve has threatened to raise rates, but such action may not be as aggressive as some observers anticipate. The gap between expectation and reality may weaken the greenback.

■ Corrections of more than 20 per cent are normal for a healthy stock market, and they usually occur every four to five years. The U.S. markets have not had such a move since the summer of 2011. Common sense suggests we are due a correction.

■ Presidential electoral cycles suggest strength in the market in the first half of a pre-election year (2015 is such a year), followed by a weaker second half.

■ Volatility has increased from the fourth quarter of 2014 into the current year, as evidenced by the choppy VIX pattern. (VIX is the trademarked ticker symbol for the Chicago Board Options Exchange Market Volatility Index.) This can be a sign of a market transition from up-trending to a corrective pattern.

■ Perhaps most importantly: Sentiment indicators are SCREAMING overbought. So-called “dumb money” (i.e., retail and mutual fund investors) loves this market, while “smart money” (large institutions, sophisticated investors, insiders) is more cautious. Historically, the current levels of “dumb money” optimism and “smart money” pessimism have led into corrections.

■ Finally, although this factor does not originate in the United States, our economy is and will likely continue to falter in the face of weak oil prices (which will eventually recover, but not likely to their old highs any time soon). Thus, the Canadian dollar will remain weak, and our bond yields will stay low for at least the time being.

Battening down the hatches

At ValueTrend, part of our systematic approach to an investing strategy has been to raise the cash portion of the equity portfolios we manage to 15 per cent each spring. My decision to raise nearly three times this minimum cash allocation this year is based on a few other factors that suggest the summer’s anticipated pullback may be a bit larger than normal.

Selling high-beta stocks to raise cash

In short, we are raising more cash than we usually do at this time of year—and we’re doing this by selling the more volatile securities within our portfolio. At the time of writing, our cash weighting is up to almost 20 per cent within the ValueTrend managed equity platform. We expect to double this cash level over the coming month—and reach nearly 40 per cent before the summer.

Where we turn for low-beta stocks

Going into the summer, our equity platform is becoming more and more focused on low-beta (i.e., low volatility) holdings for the stocks we continue to hold. Names such as the SPDR Consumer Staples Select Sector Exchange Traded Fund, or ETF, (NYSE─XLP) and interest sensitive sectors such as Real Estate Investment Trusts (or “REITs”) offer dividends plus relatively stable price performance in the face of a likely market pullback.

We’re also looking at a few individual names within the REIT group, and at the broad REIT play through the iShares S&P/TSX Capped REIT Index ETF (TSX─XRE). As well, we’re holding a few foreign stocks via American Depositary Receipts, or ADRs, such as Tata Motors Ltd. (NYSE─TTM) and China Mobile Ltd. (NYSE─CHL). These, along with the BMO Indian Equity Index ETF (TSX─ZID) and the BMO China Equity Index ETF (TSX─ZCH) offer an alternative to the overbought North American markets.

When to get back into the market

While holding a larger component of cash and lower volatility positions within our stock portfolio is the best investment strategy during a market pullback, there will come a time when we wish to redeploy our cash back into high quality growth stocks. It’s difficult to say when a buying opportunity will occur, given that market bottoms can be any time between June and October. My way of looking at it is to watch for a reversal of the factors mentioned earlier regarding market sentiment and patterns.

Typically, when the “smart money” begins buying again, and market patterns and breadth and momentum oscillators begin acting “normal”, it may be time to start buying in again.

What’s the technical support level for the S&P 500?

Further, I would expect that the S&P 500 may reach a reversal point at or near a level of technical support. Technical support comes in at 1,900 to 2,000 for the S&P 500. If the summer correction is aggressive, it could push the S&P 500 as low as 1,800, but that would be the most extreme case.

Plan ahead: Make a shopping list

While waiting for the chance to redeploy cash, we have been building a “shopping list” of stocks and exchange traded funds that we would like to buy. These are positions that we do not own yet, but would buy at a more attractive price.

I might suggest that you, too, build such a list of attractive positions to put on your watch list. One of the sectors we are watching is the Canadian banks. We sold out of our banks in the first month of this year. We’re happy to have done so, as the sector has fallen since our sell point.

Plan for ‘seasonal shopping’

We note that the seasonal pattern for Canadian banks is for an entry point near the end of the summer, and we’ll be watching to buy back in when the opportunity looks ripe to do so. Keep an eye on the BMO S&P/TSX Equal Weight Banks Index ETF (TSX─ZEB) as an ideal way to play the sector.

We also expect to rotate back into the consumer discretionary sector via the SPDR Consumer Discretionary Sector Select ETF (NYSE─XLY) when the time is right.

Time to enjoy nature (let the markets wait ’til fall)

Enjoy the benefits that spring brings to our lives. Bring that Harley Davidson out of storage, or strap on your running shoes for an invigorating trail run. But look to become a bit more defensive in your investment strategy at the same time. Like Mother Nature’s cycles, there are times to play, and times to hunker down. The time to hibernate from a harsh stock market environment allows you to relax and enjoy the world outside of your investment portfolio. Perhaps that’s the way Mother Nature intended it to be!


The MoneyLetter, MPL Communications Inc.
133 Richmond St. W., Toronto, On, M5H 3M8, 1-800-804-8846

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