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From Silver Linings to Gray Skies

“I think it was a long step forward in my trading education when I realized at last that when old Mr. Partridge kept on telling the other customers, “Well, you know this is a bull market!” he really meant to tell them that the big money was not in the individual fluctuations but in the main movements – that is, not in reading the tape but in sizing up the entire market and its trend.

And right here let me say one thing: After spending many years in Wall Street and after making and losing millions of dollars I want to tell you this: It never was my thinking that made the big money for me. It always was my sitting. Got that? My sitting tight! “

     – Reminiscences of a Stock Operator

Since I penned the “Silver Linings Playbook” for markets on February 11, 2016, the “main movements” have been up. Thinking has been a liability. Brexit, the U.S. elections, Syria, North Korea, and Comey – all reasons to think – and all distractions from the primary trend. Sitting has earned the “big money,” as it always does during long uptrends.

And a long uptrend it has become, with the S&P 500 holding above its 200-day moving average for 242 straight trading days, one of the longest runs in history.

The Nasdaq 100 Index ETF (QQQ) is currently tied for the longest streak above its 50-day moving average in history, at 130 consecutive trading days.

Above the surface, all seems to be well in the world, as I outlined recently in “Is This as Good as It Gets?” It has rarely been easier to sit still and enjoy your gains than it has been in the first half of 2017. Every minor drawdown has been met with strong buying, soon followed by new all-time highs. Equity returns with bond-like volatility – what’s not to like?

But all good things come to an end. There comes a time when thinking is necessary and dare I say prudent. Is now such a time?

You be the judge…

1) With the Dow at an all-time high, the yield curve is aggressively flattening, nearing an expansion low of 80 basis points.

2) With the Fed hiking today to a range of 100 to 125 bps (its 4th hike since December 2015), short-term yields are at their highest level since 2008. Meanwhile, long-term yields (10-year and 30-year) are at 7-month lows.

3) Credit, which had been a bastion of strength since February 2016 is starting to show some signs of weakness. Energy spreads, which caused problems for markets back in 2015-16, are at their widest levels in more than 6 months.

4) The spread between low volatility (SPLV) and high beta (SPHB) stocks has been widening, with defensive names hitting new highs while cyclical names are struggling to remain positive on the year.

5) Momentum stocks, which have been leading all year, are showing their first sign of weakness. The fact that Goldman Sachs is “mulling the death of value investing” is an interesting aside.

6) Talk of a pickup to 5% real GDP growth after the election is not being confirmed by inflation expectations, which are hitting 7-month lows.

7) Speculative fever seems to be waning in other asset classes, as evidenced by the 38% drop in the Bitcoin Investment Trust (GBTC) over the last 6 trading days. In early June investors were paying a 133% premium to buy this trust. Today that premium is down to 42%.

8) Jeremy Grantham, who has been forecasting low U.S. equity returns for the past seven years based on elevated valuations, is throwing in the towel. “This time seems very, very different,” he wrote in a recent piece arguing why higher equity valuations will persist.

9) The Nasdaq 100 ETF (QQQ), which as mentioned earlier is in the midst of a record uptrend, is showing higher volatility on higher volume. For the first time in a long time, there at least appears to be some uncertainty as to its near-term direction.

From Sitting to Thinking

As I write, all is calm in the world. After the Fed hike and announcement of future plans for a balance sheet reduction, the S&P 500 finished down only 2 points. The Dow hit a new all-time high. The Volatility Index (VIX) remained at one of its lowest levels in history (10.64).

It is the complete opposite of the backdrop on February 11 of last year. This has me thinking, about the risk/reward in a market (S&P 500) that has risen over 35% since that time. The above factors (some objective, some subjective) are not by any means absolute, but taken together point to a less favorable position.

Whether that less favorable risk/reward manifests itself in a 5% correction, a 10% correction, or no correction at all remains to be seen. Just because the skies are gray doesn’t mean it will actually rain. But it does mean that if you don’t bring your umbrella and it does rain, you will get wet.

Depending on your time frame, you may or may not care about getting wet. Most investors can handle getting a little wet. Fewer investors can handle a downpour. Fewer still can handle a hurricane.

The problem is that no one rings a special bell ahead of a hurricane in markets.  There is no way to tell, in advance, the difference between a drizzle, a downpour and a flood. As such, if you want to manage risk and can’t handle a large drawdown, you have to behave the same the same way every time the evidence points to a less favorable risk/reward. Because you just don’t know when the next flood is coming.

If you want to protect on the downside, you have to be willing to be wrong, early and often. There is no other way. You have to accept that the rain may never come.

***

Related Posts:

Is This as Good as It Gets?

Silver Linings Playbook

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This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.

CHARLIE BILELLO

Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts.  He is the co-author of four award-winning research papers on market anomalies and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors and previously held positions as a Credit, Equity and Hedge Fund Analyst at billion dollar alternative investment firms.

Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.

You can follow Charlie on twitter here.

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