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I have the great good fortune of attending a lot of professional sporting events. Some of the most memorable and rewarding experiences are close games determined in the fourth quarter. So why do so many sports fans either never go to games or, even more inscrutably, leave with 6 minutes to go and the game still tied? And then there are those who stay till the bitter end, after all the starting players have been substituted out, getting caught in the worst traffic possible. It’s about the nature of crowds, risk tolerance, information, which all seems analogous to people’s action in this bull market.
First the party poopers- they don’t go to the games because the tickets cost too much. They use the excuse that the game isn’t as good as it used to be, and the players aren’t either. Sound familiar? These are the perma-bears and deep value guys who have missed the market, or called to short it at each turn. They are one trick on a pure valuation basis. They are right about valuation but it hasn’t mattered yet and they have missed a great game. Did they really expect that with trillions of central bank conjured dollars, yen, and euro coursing through economies with low inflation that stocks would be cheap? They don’t need an exit strategy because they are not in the arena. Interestingly enough, some of them (I won’t name them here but its public knowledge) are throwing in the towel and may now get back in the arena.
The next group is the most beguiling at the game, and in the market. The game is tied midway in the fourth quarter and they get up and leave the arena. Even though the best may lie ahead, they are so parking-lot-traffic risk intolerant that they are willing to miss the best parts. These are the people that left the Super Bowl thinking Atlanta had it in the bag. In the markets, for example, they probably have missed an ongoing great move in emerging market equities. These equities are up 19% (total return) in a year and still cheap on an absolute and relative basis. Just getting back to prior highs for emerging equities is another potential 35% upward move. Closer to home, history shows that big bull markets – and we are in one – end with a bang. The last 12 months of a big bull market can show huge gains. Currently our markets are up 13.8% over the prior 12 months. In 2000 and 2007 the 12 month gains at the peak showed 23% and 26% gains, respectively. The key to not leaving too early and missing the good bits is to study the game and have a plan. More on this later.
Inevitably most people stay through all the games good and bad. It’s like buy and hold. You always get the great games, but you also see some stinkers for too long, plus you own the traffic problem on the way out. You get to see the Patriot’s comeback and that amazing three-pointer at the buzzer to win the game. But you also get the 2000 and 2007 market meltdowns with it.
What’s our plan on exit? First and foremost, we are only partially in the arena. We have a highly diversified portfolio of stocks, fixed income, precious metals/commodities, and truly uncorrelated assets. But we will exercise our plan to reduce market risk further if we see certain key indicators. This is the sell high part of buy low/sell high. Here is a list of a few key indicators we monitor and are easy to watch:
If we get a 12-month run up similar to the run ups at the 2000 and 2007 peaks, we will take risk out of stocks and high yield bonds.
If interest rates and stock prices get consistently uncorrelated (rates up, stock prices down) then we will sense the market has begun to see, and fear, inflation. Time to derisk.
We watch certain key S&P sectors for the relative performance – financials and utilities especially. Too much underperformance from those groups and we will derisk and cut bait.
Watch the NYSE daily advance/decline line and the new highs list. If either start lagging, get your sells in order. Combine that with a low put to call ratio and we are gone.
Also, watch the crowd movements. We look at a moving four-week sum of flows into equity mutual funds and equity ETFs. This, like most sentiment indicators, is contrarian. We want to buy when people are selling and vice versa. Right now, the indicator is bullish because people are slightly redeeming their equity investments. If this were to become a $40 billion positive inflow- count us out.
Even with all these indicators, can we miss it and stay too long? Sure, but then we won’t fight the trend. So, if the SP500 total return index 3-month and 10-month moving averages cross in a ‘death cross’ (3-month below the 10-month), then we are out.
Lot’s to worry about – it’s our job – but right now, few if any of these are in the red zone. So, we stay with stocks and high yield bonds but, we are watching more intently, have mapped out the way to the exit, and have our parking ticket ready. All the starters are still on the court and the game is really close so stick in there and enjoy the fourth quarter!