In short order we caution against volatility ahead for the S&P 500, FTSE All-share and other major market indexes.
I was working on constructing a US & Canada based Dividend Aristocrats portfolio recently and I came across something interesting. I found an ETF that had excellent, quality companies that were well diversified and fairly low cost. Great performance. When I had a look at the detail underneath the holdings I noticed an interesting phenomena:
Do you see it?
Fund managers and big money managers time the market all of the time!
The first thing is that the fund itself was started during a time of economic uncertainty. DGRO was launched in 2014 and most of the assets were invested during the 2015-2016 market drop. That’s interesting isn’t it! To be fair it makes sense. If you were going to start a fund and your career was riding on it doing well, would you start in 2014 or 2020?
Realistically – you wouldn’t start a fund now. The market is at all-time highs, sentiment is extremely positive, and the prices for common shares in businesses are richly overvalued. Timing is everything.
The second point is that the vast majority of the holdings in this fund were bought during times of maximum pessimism. Why are the majority of the holdings bought in December? Apple was purchased in December 2016 when the market had traded flat for a year. Verizon and Chevron were purchased on December 21st, 2018 during a brutal -17.5% sell off and about 4 days prior to the absolute bottom of the market. That’s amazing timing and an awful coincidence.
In short – market timing is extremely important if you are starting off with investing. And 51% of millennials don’t own stocks, so that applies to a good chunk of you! If you can figure out where you are in the cycle and be patient, and wait, you may find an ideal opportunity to load up on discounted, high quality stocks. All you need to do this is (1) know what you want to buy, (2) know what signals suggest the stock market is over-bought or over-sold, (3) have money and a brokerage account ready to buy stocks.
Why January 20th, 2020 marks a turning point
I can’t predict the market with precision- if I could I’d be a billionaire.
That being said I can suggest when the likelihood is extremely high for a sell-off of 8-10% within the next couple of months or certainly within the calendar year. Let’s say before March 2020.
The following very granular measures of market sentiment suggest that this market has got well ahead of itself and is extremely over-valued:
The New York Stock Exchange new highs-new lows index measures the proportional amount of stocks that have reached all-time highs and then compares it to a 200 day moving average. Friday 17th January’s close – at 636.0 – is above any recent high in the past ten years.
The NYSE Bullish Percent Index measures where sentiment sits and suggests that just under 70% of market participants are bullish (positive) on the overall direction of stocks. Note how quickly readings between 75-80% have corrected, at times within several months.
The CBOE put/call ratio measures derivatives activity for traders who bet on the direction of the market. High readings suggest traders have a high degree of negative or bearish sentiment towards the market. Low readings (below 1) or ultra-low readings (currently 0.48) suggest an excessive amount of positive or bullish sentiment. One way to view this is as a contrarian: excessive positive exuberance tends to lead to a correction or event that brings prices down closer to their average
One of the classical measures of the market – the VIX – measures volatility. At 12.10 the reading is very low and suggests that we are due a return to volatility. That reversal often happens within 2-3 months.
S&P 500 Index and how high/low it is relative to the P/E (price-earnings ratio). During periods where the index is significantly higher than the red line, which represents a P/E of 20, we tend to see reversals follow the trend that lead to a significant reduction of 10%+ in the index.
What do you do?
This does not mean moving into cash and with a blunt instrument waiting for the market to correct. Over long periods of time that leads to dreadful performance unless it is linked to the 200-day moving average or a back-tested approach.
What it means is taking money off of the table and waiting for assets to be more traditionally undervalued.
I prefer a slightly less than 50% equity allocation in today’s market and a strong preference towards dividend and income paying securities. That includes preference shares and bonds, on the safety side, and even guaranteed fixed instrument savings.
One thing that hasn’t happened is a deceleration in the metrics above.
I mean to say this is an attempt to call the “absolute top” of the market, when in fact, it is quite possible that we see another 5% rally from here.
The discerning investor could track these metrics and look to sell their risk assets once the measures turn in the opposite direction. The challenge is that measures like volatility – through the VIX – tend to reverse very quickly.
The fact that these measures are so high doesn’t necessarily mean a 2008- or 2000- style crash is coming. It’s possible. However, it is much more likely that we see a correction since they tend to happen every 12-18 months.
Equally like we experienced in December 2018, the measures can quickly turn to suggesting we are massively over-sold, and in which case you will be buying the shares back at a lower price. At Frugal Investors we intend to cover this as well and update regularly on what the Market Timing Model says about where we are in the market.
If you have money laying around it might be prudent to wait and see what happens before diving into the market.
Plan – Do – Check – Act.
Stick with Plan for now and be ready to strike!