Lighthouse or Barge
I know it has only been a month since I last wrote but it sure feels like it has been a year. I struggled to summarize all the actions and updates we have seen in the past four weeks. The stock market continues to surprise us, sometimes even with significant swings in the same trading day. As I sat writing this, the Dow Jones Industrial Average was trading up about 1.4%. I took a short break 45 minutes later and to my surprise saw that it was now down -.4%. That is over a 400 point reversion in under an hour and speaks to the continued volatility and uncertainty we are seeing day to day within the market.
If you have been following along with me for the past few months, you know our firm has been extremely concerned about the current market environment. Stocks in the S&P 500 are currently trading using 26X earnings. The typical ratio is 16.5 and it means that the market is significantly disconnected from corporate earnings. It does seem that the market is saying that valuations are not important. However, if our recovery continues to slow, and employment and wages continue to worsen, they will. The current extremes shown between market and corporate profit deviations should be sounding alarms.
Speaking of deviations, the NASDAQ is current trading 23% above its 200 moving day average. Averages work as a gravitational pull to bring prices closer in line to it. That is the way averages work. The further extended a stock gets from its moving average, the more likely the pullback will be significant. I use the analogy it is like a rubber band being stretched and stretched, eventually it will be unable to be stretched any further and it will snap back as far as it was originally pulled.
The significant concentration amongst the major indexes points to increasing weakness in the market. Currently over 26% of the S&P 500 return year to date is a result of Apple, Amazon, Google, Facebook and Microsoft. Additionally, if we look at market capitalization those same five companies make up the same amount as the bottom 394 companies in the index. These are staggering numbers that point to the overall weakness, despite the recovery we have seen.
The Federal Reserve has undoubtedly assisted with “helping” the market by injecting massive amounts of liquidity in March and April. I say “helping” because what we are now left with are waters that are foggy and difficult to navigate because many numbers have become skewed. It is now tough to see if the light we see in the distance is the safety of the lighthouse or a runaway barge that is heading straight towards us. The math and rules tell us that we are not out of danger and we should continue to move methodically.
We did take three minority equity positions last month using our math and rules-based process. We tactically chose areas in consumer cyclicals, industrials, and online retail as they show great opportunity based upon their relative strength and momentum. We also steered clear of areas with decreasing relative strength and momentum as they will typically become drags on performance. We are still avoiding areas that are heavily weighted in the major indexes as we see the elevated risks outlined above. Since taking our three positions, they have collectively seen returns of 9.85% compared with S&P500 return of 3.86% over the same time period. This is the advantage of using a tactical approach that uses math to make investment decisions.
As more of the fog continues to clear, we will continue to take new equity positions. We continue to be aware of the increased risk within the markets and will manage our portfolios accordingly. Market greed is at all- time highs, investor sentiment is that “stocks can only go higher” and put- to- call ratios are extremely low. These are typically seen right before markets see a top. I am not saying that the market cannot go higher in the short term. But I am saying it would not be prudent to ignore all the headwinds and risks that currently exist for the market. Complacency, especially during market tops always wind up being detrimental. We need to know if the distant light we see is coming from the safety of the lighthouse or from the runaway barge heading straight for us. My job as an advisor is to protect my client’s principal, reduce risk, create wealth, and avoid being capsized by the unexpected barge: all at the same time.
Ashley Rosser AIF BSN