by Craig McFadzean and Christopher Crowe, Turn8 Partners
The last couple of weeks have been disconcerting as the rally of the last six months seems to have hit a wall. The market sold off two weekends ago, had a reprieve for a day last week, then finished off with a nasty slide that continued into this week with huge intraday swings. We believe there are two primary reasons for the selloff: Market fatigue & Style Rotation. As a result, on Monday, the 7th, we started to raise cash, rotating away from some of our momentum holdings and placing Stop Loss orders as a precautionary measure should the correction get ugly.
Market Fatigue - “how much higher can this market go?”
We’ve been in this situation a couple of times over the last year, but the market has been resilient and shrugged it off. It may not be as easy this time due to several headwinds.
First headwind – The current bull market reached the five year mark on March 9th. This is meaningful because the average bull cycle since the Great Depression has been 3.8 years with only a handful lasting more than five years. More interestingly, those that lasted longer than five years typically saw only a few mini corrections of 5% plus over the first five years followed by frequent 5% pullbacks as the cycle approached the market peak. Sound Familiar? This seems to be the pattern so far in 2014.
Second headwind – The Federal Reserve began reducing their Quantitative Easing programs last Fall and have continued reducing their liquidity program this Spring. The question many investors wonder is how much the stimulus drove the market the last five years versus economic recovery?
Third headwind – Price. Looking at common ratios such as price-to-earnings (P/E) shows the market at a price level that no longer makes it as cheap as it was last year and many measures actually show the market as overvalued (see Chart 1 below).
Chart 1 = Shiller P/E is considerably above the mean
Fourth headwind – The verdict is still out because we are in the middle of first quarter earnings season, but we have seen a greater number of companies miss on their numbers (see Chart 2 below).
Chart 2 = The nuber of companies beating estimates is decreasing
Fifth headwind – We are approaching the “sell in May and go away” time of year, which statistically contains the worst performing months on average over history particulary in mid term election years (see Chart 3 below).
Chart 3 = Average monthly S&P performance shows tough summers
Style Rotation - Momentum versus Value
We have seen a violent shift in the market from pricey, momentum, growth stocks to value stocks. We’ve seen this within sectors, within markets, and across geographies. Examples of the shift from momentum are moving from the high flying internet stocks like Amazon and Netflix to large cap tech such as IBM and Microsoft, or from biotech to utility and REITs, and from the US to Emerging Markets.
Chart 4 = Risk appetite rolling over as bearishness increases
Tackling this market - Turn8's Approach
We believe market risk is elevated right now. There is an increased potential of a prolonged pullback and limited upside potential for the next month or two. We do still believe the second half of the year will be ok and the broad recovery will continue, however patience is required right now and we look to take advantage of the pullbacks to rotate into holdings we have had our eye on.
Swing Model (short term model)
What we’ve done?
The Swing Model makes up 10% to 15% of everyone’s account and is our first line of defense. We had this model at 100% “Risk On” until end of January using the S&P500 ETF and then split the exposure in the model to include 50% short-term government bonds. Last Monday, April 7th, we took all risk off the table for the time being.What we are monitoring?
We are watching the earnings releases and other fundamental developments, but more importantly, the technical signals such as MACD, Relative Strength Indicators, Buying Volume, Option Trading as well as others. It’s the technical signals that will be key to determining when risk calms down and we can shift back to more Risk On.
Core Equity Model (medium term model)
What we’ve done?
This is a medium term model and therefore we are less concerned with the fits and starts of the market that the nimbleness of our Swing Model is designed for. The key over the medium term is the overall macro sentiment, but the Core Equity does also act as the second line of defense.
- This key shift we made at the start of last week was switching our largest position, the broad S&P500 iShare (ticker = IVV), into a pure value ETF covering the S&P500 called Rydex Guggenheim Pure Value (ticker = RPV). With the challenges facing growth and momentum stocks we wanted to reduce exposure to these types of holdings by focusing on value stocks that currently offer less downside and likely more upside because of a more realistic price per share.
- We also sold our small cap position which presents more volatility. The proceeds have been kept in cash for the time being.
- Lastly, for now, we placed stop loss orders on all the sector specific exposures to minimize losses, but also hedge our bets and stay invested should the market bounce and the correction ends up being a mini correction and not a full blown slide. We have the stop loss orders placed at key support prices.
What we are monitoring?
If we see earnings deteriorate, more dangerous geopolitical flare up, or simply key support levels of the market break, then we will move a little more into cash. If support holds then we look to continue to further rotate into investments representing better value and away from momentum. A prime example of this would be further expansion of our Emerging Market exposure, which traditionally are considered riskier, but not right now. Emerging markets trade at much lower price-to-earnings (P/E) than Western markets because they have been rather flat the last couple of years, which means they may have less downside and more upside. We have also started to see the money flow this way as the month of March saw $7.9 billion net outflow of US ETFs while the emerging market iShare (EEM) had net inflows of $1.4 billion. The international markets we are closely monitoring are Sweden, Indonesia, Vietnam and India.
Global Alpha Model (long term model)
What we’ve done?
This is our 20 to 25 stock model where we try and own a good group of companies given the market trends and theses. We are generally comfortable being fully invested in this model, but have started the process of tweaking exposures for the value shift we’re starting to see. We sold 7 of our 25 stock positions last week. These were either higher momentum holdings like Gilead, or holdings we currently have less conviction in like Costco, or holdings that recently ran up substantially like Caterpillar. We are keeping the proceeds in cash for the time being.What we are monitoring?
This is our long term model and therefore we don’t want to be out of the market too long although we have little problem being patient. We have our eyes on several holdings within our hot watch list and look to invest in a few holdings over the coming weeks.
Please don’t hesitate to reach out should you have any questions or concerns.
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Turn8 Partners is a discretionary investment management firm providing comprehensive Wealth Management Advice and Investment Services to exclusive clientele in Canada and the United States. Combining forward-thinking solutions, based on a professional foundation, we implement and manage customized wealth management strategies to ensure the realization of our client’s goals.
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