Summer Crash of 2016?
Amazing what a difference a day makes. On Tuesday of last week, I wrote the below article which was set to be published on Marketwatch.com for the following day. Unfortunately, there were some technical issues during the submission process, and I got too busy to try to re-submit the writing Thursday. It turns out with hindsight that was perhaps my last chance to do so, as a Summer Crash (primarily in Europe) began to take place.
Since it never got published prior to Friday, I’ve put the writing below. A couple of quick points before reading it though. First of all, the “Brexit” news should never have been a surprise. All polls have a margin of error which can be quite large. The market seemed to be convinced that Brexit would not happen, when factually it was always a toss-up. When real uncertainty is ignored and markets act with bravado, the result tends to be a surprise sell-off and panic. I did not speculate in the Tuesday Summer Crash writing that “Brexit” was the reason for a major sell-off to come.
Second, and perhaps more importantly, I don’t think this is over yet. Intermarket trends suggest broad defensiveness prior to Brexit becoming the focal point. We will only know with hindsight why, but I suspect another drop may be coming which is US-led given the duration of defensive posturing in the last few months, similar to behavior last seen in the lead-up to the Summer Crash of 2011.
All of our strategies are predicated on the anomaly we show in each of our 4 award winning papers that volatility is predictable and can be positioned for in advance. If the cycle for more frequent volatility has finally begun, those who have been contemplating when to pull the trigger on using our mutual funds and separate accounts may want to finally do so. Strategies which thrive on alpha generation through down-capture need to be operating in a cycle where there is downside to capture. The last few years have been all up, no down. What is missed by many who live in the small sample is that the outperformance that comes from taking less risk at the right time is far greater and far faster than trying to take more risk on the upside.
Schopenhauer’s timeless quote I believe will be quite appropriate as we enter the third stage of truth.
Summer Crash of 2016?
“All truth passes through three stages. First, it is ridiculed. Second, it is violently opposed. Third, it is accepted as being self-evident.” – Arthur Schopenhauer
Something doesn’t add up.
I’ve done my best to “evolve” over the last few years. Five years ago, when I began actively writing for websites like Marketwatch reviewing intermarket trends, I took the approach more of making a “call” on the direction of stocks and bonds (risk appetite vs defensive stance). The call that got me most attention (and got me in the media) was the “Summer Crash of 2011,” whereby 2 months before I argued defensive sector strength, Treasury behavior, and intermarket analysis all pointed to a “Great Re-Adjustment” likely in the summer (http://www.marketwatch.com/story/money-managers-called-the-summer-market-plunge-2011-08-10). August happened, and stocks went through one of their most volatile periods in history.
Lucky or smart? The reality is I have no idea. But when defensiveness rules market behavior in a big way, something is likely wrong with the overall trend and the conditions that favor volatility. Since those days of making calls, I’ve co-authored four award winning academic papers (https://www.pensionpartners.com/research/white-papers/) which quantitatively prove that 1) volatility is predictable, 2) anomalies and strategies have cycles, and that 3) being down less over long cycles matters more than being up more. As a matter of fact, we’ve shown that wealth comes not from taking more risk to get more return, but rather less risk at the right time.
I believe there is a growing possibility that a nasty decline is to come in the near-term not based on opinions, but based on sector and asset class behavior. This is by no means meant to be alarmist, nor is it meant to pound the table that we are going to collapse here. Just because you slow down entering a storm and a crash never happens does not mean it was wrong to take caution. And this, I believe, is a time to be cautious.
So what are the warning signs? As we showed in the 2014 Dow Award winning paper “An Intermarket Approach to Beta Rotation” when Utilities outperform the broad market on a short term basis, volatility and drawdown risk tends to rise afterwards. Utilities (XLU) relative to the S&P 500 (SPY) have remained stubbornly high, and may be on the verge of a breakout.
As shown in the 2015 NAAIM Wagner Award winning paper “Lumber: Worth Its Weight in Gold” we showed that when Lumber (cyclical) outperforms Gold (GLD), volatility (VXX) tends to rise afterwards as well, and that signal has preceded major downturns in stocks. Lumber has now recently begun to underperform the yellow metal.
Stocks remain above their moving average, so this signal has not yet flipped. Moving averages, similar to Utilities and Gold, tend to anticipate higher or lower volatility regimes. So for those more on the bullish side, this is your main argument in the here and now.
Bottom line? There is enough defensive behavior here to stand up and take notice. And given just how “resilient” stocks have been, this seems like the kind of environment whereby the stock market’s muscle just gives out. Now keep in mind that every signal has false positives, meaning there are times when Utilities outperform and Gold outperforms, but stocks don’t go down.
Will this be a false positive or not? I’ll let you know in a few months. But this is a time where complacency, combined with defensiveness on the fringe, might result in a coming storm.
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.
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