May 2016 Portfolio Update

After lagging the recovery, the last couple of weeks in May were very favorable for the portfolios as Technology, Financials and Small Caps outperformed. It looked like our growth oriented allocation was going to be a strong performer for the rest of the year. Janet Yellen, along with voting and non-voting members of the Federal Reserve, had been talking about raising interest rates in the months to come as the economy gained strength.

I have been optimistic about how the portfolios are going to perform because the economic data has been positive. The Department of Labor reported that the four-week moving average of unemployment claims ending May 28th was 276,750. This is impressive, because it marks 65 consecutive weeks of initial claims under 300,000. This is the longest streak since 1973!

However, on the morning of June 3rd, I was about send my monthly email when news broke that nonfarm payrolls rose a mere 38,000 and everything changed. Instead of hitting the “send” button, I immediately entered trades to begin exiting out of all Rydex funds in the portfolios.

Nonfarm payrolls have been falling since February. The monthly changes in nonfarm payrolls were 223,000 in February; 186,000 in March; 123,000 in April; and 38,000 in May. With the May news, my perspective of optimism turned to one of concern.

It helps to look at the Federal Reserve Economic Data, or FRED graph, of the monthly change in nonfarm payrolls. When the monthly change is on a downward trend approaching zero, there is often a recession in the months to follow if that monthly change turns negative. This data does not definitively mean there will be a recession. There are instances in the mid-80s and mid-90s where nonfarm payrolls briefly turned negative and there was no a recession. Given the current state of the global economy, my concern is a U.S. recession could be very bearish for equities.

There are other factors that led to my decision to start selling positions:

  • The S&P 500 has failed to significantly break past the 2,100 level several times in the past 12 months. If the S&P 500 fails to rally forward from here, it could suggest a retest of its prior lows near the 1,900 level. A 200-point drop from here would be a loss of nearly 10%.
  • Historically, the six-month period from May through October underperforms the six-month period from November through April. Hence the phrase, “Sell in May and go away.”
  • The weekly Lipper Fund Flow report shows that retail investors in May have been yanking money from equity funds and putting their money into either bond funds or cash. This suggests investors are becoming bearish on equities.
  • The Commitments of Traders report from May 27 confirms the recent trend of rising interest rates on the 10-year Treasury is starting to reverse direction. A reversal suggests rates could fall from current levels.
  • The Commitments of Traders report from May 27 shows that VIX futures, one measure of the stock market’s volatility, are spiking. Rising volatility suggests equities could become volatile and could cause stocks to pull back.

The other big reason for the move to cash is that I want to hold on to as much of the recent gains as possible. I am erring on the side of caution. If the market does pull back, or worse, if the economy recesses, the growth oriented and inverse bond positions we currently are in would likely perform very poorly. If this recent nonfarm payroll data turns out to be an anomaly and the S&P 500 strongly breaks through the 2,100 level, it is very easy to trade back in under the new system.

If the economic data continues to worsen, it will likely create a shift in the sector rotation model to ultra-defensive sectors such as gold and long-term bond funds. Under the new system we fortunately have more options to capitalize on these shifts, plus the ability to implement Portfolio Shield™ on each new position in order to limit losses.

Regardless of which direction the market may move, I will be on the lookout to take advantage of any opportunities that present themselves.