June 2016 Portfolio Update

Beginning with the this update, we are going to test out a new video format. The monthly print updates will be strictly limited to investment and management updates regarding the portfolios. The video will give you my thoughts on the latest news news events and how they affect the financial markets.

In this months’ video I am going to answer:

  • Thoughts on Brexit.
  • Will the Fed raise interest rates?
  • The Initial Claims for Unemployment have been near historical lows. Isn’t that a sign of economic growth?
  • Why is the stock market near all time highs?
  • What are the odds the economy is about to fall into a recession?

What a wild couple of weeks it has been! Brexit shocked the stock market by causing $3 trillion in paper losses. Fast on the heels of Brexit, equity markets nearly reversed those losses in a matter of days.

Fortunately, the portfolios were not impacted since my research dictated a move to cash in early June. While the broad market has nearly rallied back, the portfolios actually ended up in a better position. This is because several of the sectors the portfolios were invested in did not rebound back.

In this edition, I will share the decisions behind the move to cash and why I avoided this recent rebound. I will also discuss my studies of Volume Price Analysis and when I think we will be moving back into the market.

Performance Update

For the remainder of the year, I will speak in general terms about returns. Due to the transition, not all accounts were converted to cash on the same day. This means there will be a slight variation in returns depending upon when your positions were sold. For that reason, I am unable to publicize returns through year-end.

If I had not moved the portfolios to cash when I did, the current returns would not look very good. Compared to the funds I benchmark against, the portfolios are in a better position now than they were against those same benchmarks a month ago, despite being in cash.

The Call to Cash

In early June, I made the call to exit all domestic equity positions to cash. By the time British citizens cast their votes to leave the European Union later in the month, I had already made the call to exit the International and Emerging Markets positions.

Many hours of research went into the decision to sell equity positions to cash. I assure you it was not a decision that came easily. Looking back, as Brexit was taking place and global equity markets went into freefall, that decision was one of the best moves I’ve made as a portfolio manager.

As a result, I thought you’d be interested to learn about my research behind those decisions:

  • May Nonfarm Payrolls Report: The May Nonfarm Payrolls report showed the economy created a mere 38,000 jobs in May. This is historically one of the best months for job creation and marked the fourth consecutive month of declining job growth. Excluding January 2016, May also marks the eighth month of declining job growth. To put this into perspective, the economy has created 580,000 jobs since February, while more than 4 million Americans have filed for initial jobless benefits during the same timeframe. This is huge red flag!
  • CBOE VIX Futures Report: Every week I review the Commitments of Traders data and build the data into several charts I’ve created. The VIX Futures data (which deals with implied volatility) showed a huge spike in one of the data sets. I noticed whenever this spike occurs, there is a high probability of a stock market correction on the horizon.
  • Economic Calendar: The upcoming economic calendar for the remainder of May did not show any major economic releases planned that would provide a strong direction for equities.
  • Analysts Mispricing Brexit: Entering into the week of the Brexit vote, analysts predicted that if there was a vote for Bremain (those Brits who wanted to remain in the European Union), that U.S. equities could rise upwards of 10%. If there was a vote for Brexit, they predicted equities could drop 10%. If these analysts were correct, then what they were suggesting was a massive mispricing in U.S. equities. Given the size of our stock market, the odds of such a mispricing was unlikely. A look back over the data revealed weak economic data and a further weakening of corporate profits. Because of this, I felt the probability of equities dropping 10% was far more likely than equities rising 10%.

Volume Price Analysis

Over the last year, I have been studying technical analysis and sector rotation modeling in an effort to give us any edge possible. Most recently I began studying Volume Price Analysis, which looks at the relationship between price movement and volume.

Compared to modern day technical analysis driven by charting, Volume Price Analysis traces its roots back to the early days of ticker tape trading. Through analysis of volume and the corresponding price movement, one can see what the insiders or large traders are doing. The benefit of knowing what insiders are doing is that one can seek to trade with them instead of against them.

When a market is in a consolidated pattern and moving between an upper and lower bound, one should wait for a large spike in volume followed by a corresponding move in prices. If the market moves above the consolidated range, then the market is likely to move up further. If the market moves below the consolidated range, it is likely to continue moving lower. The way to interpret this is if the market moves up from the consolidated range, the insiders were buying. If the market moves lower, it was because the insiders were selling. While most people trade opposite of the insiders, the objective should be to trade with them.

Looking at the last two months, the market was in a consolidated pattern with well-defined high and low points. On the day of the Brexit vote, the markets broke the lower bound on very high trading volume. This would normally be an indicator that the big money is selling and prices should move downward.

However, three days later the market moved up with declining volume. A market moving up on declining volume is a big red flag. According to Volume Price Analysis theory, when the market moves up on declining volume it is a signal to either sell or stay in cash because another selloff is likely on the horizon.

Based on recent price movements and volume, the portfolios are properly allocated by being in cash. The next move to buy in should be based on the next high volume price movement. That next movement could be a signal to buy in or a signal to remain in cash. Either way, as of July 1st the price movements in this most recent rebound show signs that prices are likely topping out.

Avoiding the Rebound

Based on the Volume Price Analysis research, I made the call to stay in cash as the market rebounded post Brexit. Another reason that factored into this decision was that dealers were massively marking up prices prior to market open each day. For the most part, stocks open at, or near, the previous day’s closing value. With the opening bell on June 28th, dealers began to massively mark up prices at open. This gave the appearance there was a massive buying rally in the equities market. It continued for four consecutive days.

In my opinion, this type of move is one for day traders, or people who have the systems and capabilities to quickly react to shifts in the market. It is not a move for a portfolio manager who hopes to stay in positions for a period of time before exiting. I believe my role is to make smart moves, not risky moves. Paying a premium to buy in is a very risky move.

The Move Back In

I do not plan to stay in cash indefinitely. On July 8, the June Nonfarm Payrolls report will be released.  I plan to reassess our position at that time. While analysts are saying Wall Street is currently focused on earnings, I find that hard to believe. Corporate earnings and profits have been falling for several quarters, while stock prices have been rising. I believe what really matters is how many jobs the economy is creating.

If we take a broader view of the economy, it showed signs of slipping into a recession in December 2015. Since then, the economy has started to pull out of the dive, but economic data is beginning to flat line and show signs the recovery is starting to roll over and potentially stall out. Since Nonfarm Payrolls are a leading indicator of the overall health of our economy, my concern is the stock market will sell off if the June report shows further signs of weakness.

The other factor here is that something seems amiss. According to my modeling, equities have largely rebounded post-Brexit and appear to be pricing in further economic growth. At the same time, bond yields have plummeted to ultra-low levels and according to my modeling appear to be pricing in further economic weakness. This sort of divergence between stock prices and bond yields does not make any sense!

Limited Number of Options

Here are the scenarios and the risks associated with each:

  • Economic Growth: In this case, I should take a long position in equities and a short position on bonds. The risk is that if the market drops, the portfolios will take substantial losses.
  • Economic Weakness: In this case, I should take a short position in equities and long position on bonds. The risk is that if the market rises, the portfolios will take substantial losses.
  • Traditional Diversification: Most asset allocated portfolios take a long position on equities and a long position on bonds. Based on the recent divergence in equity prices and bond yields, the risk of this type of portfolio is that it will not offer much benefit regardless of how the market moves.
  • Cash: In this case, we can wait and let prices and volume dictate our next move. If there is a strong signal that prices will go up, we can get in. If there is a strong signal that price will fall, we can wait and buy in once the dust settles.

I intend to capitalize on this move to cash and use this position to our advantage. I want to buy in at a point that gives the portfolios an opportunity to make a positive return without having to make an immediate trade back to cash. Rest assured, I will keep you apprised of my plans as the data and the markets unfold.