Market Bottom February 2016

I chose February 17th to do a full rebalance on all portfolios. This included bringing in cash for those who made contributions or transfers in the past few months.

There will always be headwinds and a chance the broad market could dip again. However, I chose this date because the market dynamics appeared to present an excellent opportunity to buy in at very low levels. Downside risks are now waning and the upside potential is high.

During the current rebound, I will closely monitor sectors and make adjustments as necessary. I believe the investments I chose, as detailed in my last newsletter, will offer the greatest upside potential. It is always possible other data may dictate further changes.

You may be wondering at this point if the market has bottomed out. In my opinion, we may be very close to a market bottom, if we already haven’t seen it. The only way to be certain is to look back in a few months.

Now I’d like to take a few minutes to share with you some of my thoughts on what is happening.

Good news

  • The recent economic data has not been bad. Job openings are increasing slightly. This suggests employers are looking to hire. Jobless claims are falling with fewer people filing for unemployment benefits. This means less people are losing their jobs. Retail sales inched up a bit, which indicates consumers are still spending.
  • Safe haven assets, such as gold, are starting to sell off. This may indicate investors believe the worst is behind us.
  • U.S. Treasuries are also selling off. These are commonly considered a safe haven asset. As investors sell bonds, interest rates are pushed back up. This trend was validated on February 12th in the Commitments of Traders Report. It showed a reversal of long bond positions, indicating that interest rates would likely rise again soon.
  • Big hedge fund traders are losing interest in the U.S. dollar and turning their attention to other currencies. This could potentially cause the dollar to begin a long downward trend. A falling dollar is usually bullish for equities.
  • The number of short positions on small and mid-cap stocks is receding. This may indicate that small and mid-cap stocks could be near a bottom.

Less optimistic news

  • There has not been much momentum behind equities during days the stock market is up. In order for a rebound to turn into a rally, the market needs to regularly close at new highs. Recent upward trends have been rather weak, but are showing signs a bottom has formed.
  • A large number of short positions have been placed on large cap stocks. This means that traders are betting the market will drop further. I pulled data all the way back to 2011 in order to find another time there were as many short positions on the market.
  • Traders are also betting on long-term interest rates falling. The number of long positions is the highest it’s been since 2011.
  • Trading volume remains at relatively high levels. Large amounts of trading put downward pressure on prices. Until the amount of shares trading begins to subside, it is likely the markets will continue to be volatile.

Looking back to 2011

  • When reviewing market data from 2011, the aftermath was very positive. Within 3 months of hitting a bottom, the broad indexes fully recovered and went on to rally for another 5 years.
  • The sectors we are in now, as well as those we are looking to adjust into, were top performers during the rebound of 2011.
  • In general, the U.S. dollar trended downward following the market bottom in 2011.

Short-term concerns

  • If the broad market fails to generate a rally, it could retest recent lows. Technical analysts suggest the S&P 500 could retest for the fifth time at a low of 1,810. If it fails to hold at that level, the new low could drop to 1,740.
  • The biggest concern at present is volatility. While volatility is nowhere near 2008 levels, it is not far off from late 2015 when the market corrected in August and again in September. Many experts suggest that in order for a rally to gain momentum, volatility needs to subside.
  • The number of short positions needs to begin backing off. While short traders cannot force a market down indefinitely, their actions can cause investors to think twice about getting back into the market.

Rapid reversal possible

Traders with short positions could force the market back up quickly in what is referred to as a “short squeeze.”

A short squeeze occurs when a trader who is short a stock (most commonly by borrowing the stock from a dealer) is forced to cover that short position. This happens because the market begins to rally.

A short trader bets on a stock dropping. If the stock starts to appreciate, the short seller has to cover their short. This means they have to buy the stock. When the trader buys the stock, it creates further upward momentum and the market rallies. This is what happened in 2011 and what I think will happen again in 2016.

While things are not perfect, it does not appear that we are on the eve of a massive recession. If anything, the economic data continues to suggest this is a Wall Street induced correction and not a recession.

Based on my recent research of hedge funds and short sellers, much of what we are seeing can be attributed to large traders taking short positions on equities and long positions on bonds. As they unwind those positions, either by choice or out of necessity, equities should rally and long-term interest rates should rise.

Effects of playing “Chicken”

In a sense, what we are currently seeing is much like the old game of “chicken,” where two drivers at opposite ends of a road race directly towards each other. Whoever flinches or breaks away first loses.

Today we see this same game being played by big Wall Street traders and Main Street investors, although investors generally aren’t interested in games. The big Wall Street traders are betting heavily on a recession. That’s because many of those same traders have significantly underperformed the market.

A recent report showed many of the largest hedge funds lost double digit returns in 2015 and were already down double digits by the end of January 2016. In comparison, all of my portfolios in 2015 had positive returns (net of fees!), and my higher risk portfolios didn’t even start dipping into double digit losses until February 2016.

These big traders are desperate to generate positive returns. But in order to short the market, there is a cost. One challenge is that every day the economy fails to recede, those costs continue to eat away their potential profits.

Another challenge involves positive economic data. Each day new economic data is released that shows the economy is not headed toward recession means these short positions may not generate any more returns.

Either of these challenges may cause traders to flinch. And once Wall Street traders flinch, a big rally is likely to ensue, which is why I rebalanced the portfolios when I did.

We continue to see information that the economy is not receding. The stock market is beginning to post more days with positive returns than days with negative returns. And on days the market does drop, there is a high amount of resistance. This is an indicator that the likeliness of further large drops is rapidly decreasing.

Only time will tell on who will flinch first. However, I believe the big Wall Street traders will be wrong. Rest assured we are well positioned to capitalize when the next stock market rally occurs.