08/04/2013 When the Bear Calls Your Name

Sector Model	XLU & XLB	0.88%
Style Model	Small Value
Large Portfolio	Date	Return	Days
CAJ	9/25/2012	-7.85%	312
ABX	4/11/2013	-31.07%	114
TTM	5/6/2013	-8.85%	89
DLB	5/13/2013	-3.91%	82
MATW	6/6/2013	6.83%	58
OKE	6/17/2013	19.42%	47
BTI	7/1/2013	5.59%	33
CLH	7/8/2013	10.54%	26
FAST	7/22/2013	7.90%	12
VAR	8/2/2013	-0.26%	1
(Since 5/31/2011)
S&P	Annualized	11.64%
Sector Model	Annualized	24.93%
Large Portfolio	Annualized	30.48%
S&P	Total	27.09%
Sector Model	Total	62.32%
Large Portfolio	Total	78.43%
Sector Model	Advantage	13.28%
Large Portfolio	Advantage	18.83%
	Previous	YTD
S&P	6.02%	19.88%
Sector Model	27.01%	27.80%
Large Portfolio	46.63%	21.69%

 

Some odds and ends this weekend before I disappear again for a few days.

I get the question a lot about the actual annualized period.  The annualized rate is calculated from the time the model was launched with real money on 5/31/2011.  The full model has had an advantage for the entire period, but the sector model has had a good run recently.

This translates to the following performance graph:

The recent outperformance of the sector model reflects the fact that the full model tends to have a good pop up at the end of the year (see 2011 and 2012).  Since we’re still in the middle of the year, we haven’t had our year end pop yet.

If that happens again I plan to investigate the phenomenon to see if there is more to it than coincidence.

Most of those familiar with cycles understand that different sectors and styles outperform on a yearly basis as well as over the course of an entire business cycle.

I don’t find the yearly “cycle” to be a tradable exercise, although some folks are able to pull out a gain.  Something like that may be happening in my end of the year pop.  I am aware of the yearly cycle, however, and make sure I filter it out of my analysis.

Over the course of a full business cycle, though, Sam Stovall gained his 15 minutes of fame creating a useful breakdown:

http://www.amazon.com/Standard-Poors-Sector-Investing-Industry/dp/0070522391/ref=sr_1_3?s=books&ie=UTF8&qid=1375583839&sr=1-3&keywords=sam+stovall

No, the book isn’t worth a 100 bucks.

A better book for less expense is Murphy’s “Intermarket Analysis”:

http://www.amazon.com/Intermarket-Analysis-Profiting-Relationships-Trading/dp/0471023299/ref=sr_1_2?s=books&ie=UTF8&qid=1375583887&sr=1-2&keywords=intermarket+analysis

Pring also has his own take on the market cycle:

http://www.amazon.com/Investors-Guide-Active-Asset-Allocation/dp/0071466851/ref=sr_1_1?s=books&ie=UTF8&qid=1375583962&sr=1-1&keywords=active+asset+allocation

Here’s my breakdown, based on a combination of those three:

XLF - Financials

When the economy is faltering the Fed loosens interest rates.  This tends to happen naturally since businesses stop borrowing when they see no end in sight to a recession, but the Fed speeds the process along to try to make things easier once businesses start getting their toes back in the water.

By suppressing the short end of the yield, they increase the yield curve between the short and long term rates.  Banks lend at long term rates and borrow at short term rates.  Once businesses finally DO start to borrow, the steep yield curve creates a profitable cushion for the banks.

So, the financial sector outperforms at the end of a bear market.

XLY – Consumer Cyclical

XLY (and its opposite XLP) are, by definition, the twin canaries in the coal mine.  XLY contains pro-cyclical stocks most sensitive to the turning of the economy.  These are things that people want (or things they need but which can be delayed, such as cars).  XLP are consumer staples… things people need most or all of the time and cannot easily be delayed.  At a market bottom, then, XLY is the first to turn positive.

XLK – Technology

When a company is going to expand, one of the first things they invest in is technology.  The basic idea is this: the better your technology, the less people you will need in order to produce things.  Before you hire, you invest in technology.

XLI – Industrials

These are the core of the large centers of employment and industry.  NOW the economy is improving in ways that normal folks on main street can appreciate.  Businesses are hiring again.  The recession is over at this point… about six months after the stock market has turned up.

XLB – Basic Materials

Part 1 of the dark side of an economy that is heating up.  The more end products that companies create, the more materials they need to create them.  As demand for materials increases, the costs of those materials increase as well.

XLE – Energy

Part 2 of the dark side of an economy that is heating up.  Energy is the power that creates almost everything we enjoy in a modern economy.  It is also the second in a one two punch of inflation, because as the COSTS of producing goods increase, the profitability of those goods decrease, choking businesses of profits.  Businesses raise prices, but prices can only go so far before customers stop buying goods.

Even worse, the cutting of business profits causes hiring to slow… or even leads to layoffs, decreasing consumer demand for the products they create.  The market is now topped off.

XLP – Consumer Staples

We looked at this already in the XLY section.  XLP are things that people continuously need.  Food is a good example.  You can’t delay a trip to the grocery store for six months like you can delay buying a new car.  When XLP begins to outperform, a bear market has begun.

XLV – Healthcare Services

Healthcare is also something that people need.  The bear is fully obvious by now, and a recession is suspected.

XLU – Utilities

The last thing that gets turned off is your power and water.  You might be eating dog food, but you try to keep from freezing to death as long as possible.  Everyone knows we are in a bear. Everyone knows we are in a recession.

XLY – Financials…

And the Fed is doing everything they can to turn things around… The cycle begins all over again.

 

The Role of the Government

These sector rotations are natural to a business cycle, but the Fed tries to speed things along. 

In Republican governments, Keynesian intervention goes as follows:

1)      Cut taxes in a recession.

2)      Cut spending in a recovery.

In Democrat governments, Keynesian intervention goes as follows:

1)      Raise spending in a recession.

2)      Raise taxes in a recovery.

Granted, part 2 of the Democrat process is partially natural.  As the economy recovers and more people are working, then folks move up in tax brackets as well and their taxes are raised automatically.  But Democrats tend to raise taxes even more, as the current President did this past year.  And, to be fair, Republicans don’t do a good job of cutting spending, as Bush II demonstrated.  But my point is that the IDEALS of each type of government are BOTH Keynesian, and even the Republican’s patron saint, Ronald Reagan, proudly called himself a Keynesian.

The idea of Keynesianism is to borrow from the next bull to ease the current bear.  The problem is that no one does a good job of paying the bill when it’s due – so we end up with endlessly spiraling debt.

But I digress.

The bullish sectors:

XLY, XLK, XLI, XLB, and XLE.

The bearish sectors:

XLP, XLV, XLU, and XLF.

These would essentially be the same whether we had Keynesian intervention or not.

 

Styles

There are also “Style” ETFs out there, and I have a style model that I reference on the blog.  I don’t actually use it to invest because it only outperforms the S&P by 5%, and that’s not enough to use as a tradable system.  But it is an aid at estimating where we are in a business cycle.

In the simplest terms, Small Caps and Growth stocks outperform in a bull market; Large Caps and Value stocks outperform in a bear market.

 

The Current Market Position

I use a mixture of Sectors and Styles to estimate where the heck we are in a business cycle.  This is the current graph:

 

The sector model is already showing a preference for a bear market, but the style model is still responding to the continual liquidity coming from the Fed.

We are as close to a market top as we can get before things start to get troublesome out there.  Buffet is probably not buying so much, but Soros is probably chasing this bubble for all it is worth.  A market top typically shows an acceleration until it blows off in a wave of euphoria that shouts down all of the naysayers out there.

Dr. Doom Roubini?  He’s bullish last I heard.

How about my favorite bear, John Hussman?  When you don’t see him every week on www.realclearmarkets.com it’s time to get worried.

Most of my favorite bears have stopped growling.  THAT’s when I pay attention.  When you can’t hear the terror any more, you are getting close to the end of that proverbial “wall of worry” that a bull market climbs to new heights.

 

Energy

It’s time for energy to get expensive.  Remember back in the Presidential election when I said there was only one tradable difference between Obama and Romney?

Right, Romney was pro energy and Obama is anti energy.

It’s time for oil to reach out and touch our pockets in a very intimate way.

And this isn’t just a matter for the coming year.  The war on energy will harm us for the next ten years.  Romney would have ended the secular bear market by 2016.  Obama will extend it until 2023, when demographic forces again pull us out on their own.

Traders don’t worry about who SHOULD have been elected, but we do need to pay attention to who HAS been elected.

Bernanke is leaving.

Obamacare is hitting.

Energy is faltering.

The lights of what economy we have are flickering.

And barring some unforeseen event, we should have a nice little bear market on our hands in the next six months.

Do I KNOW this?

No.

Anyone who says they KNOW what is going to happen is a liar.

But the odds highly favor it.

 

Timing versus Rotating

My own model, however, does not care about bull markets or bears.  It doesn’t time, and it doesn’t hedge.  What is DOES do is continuously look for bargains out there.  Bear markets create bargains.  Some of my existing stocks will get hit very hard, but they will rotate into industries and sectors that get hit even harder, so that a 20% loss will be replaced with a 30% recovery.

Backtests of the sector model show that it would have returned to all-time highs by October of 2009, instead of waiting until 2013 with the rest of the market.  That turns bears from catastrophic events to fire-sale opportunities.

The coming bear, if it does indeed occur, will not affect my methodology in the least.  Nor will it affect my “long” exposure.

If you want to time, good luck.  Keep in mind that whatever YOU fear, the Fed fears too.  Bernanke is leaving, but it looks like Larry Summers is being put up for the job.

Think you know Summers?

Even if you do, you don’t know what he’ll do.  He might very well cancel a bear market in favor of a hyperinflationary blow off. 

Typical lead lag timing tools CAN work, such as the following I built just a few minutes ago off of the observations I talked about in this post:

Looks interesting, but in these days of unprecedented intervention, shorting individual stocks is dangerous and timing the market is even more iffy.  It CAN be done.

It can ALSO backfire.

Imagine shorting QE 1, 2, and 3.  All of those are times the market SHOULD have gone down.  Using simple demographic analysis I showed a few weeks ago that the market WOULD have been in the 400s now if Bernanke hadn’t have acted.

But Bernanke did act.  We aren’t in the 400s, and if you had shorted this fake bull market you would have been destroyed.

Bear markets are dangerous for people who don’t time.

They are even more dangerous for people who do.

It CAN be pulled off.  Some folks CAN do it.  But you need a far more sophisticated model than the one I concocted above off of some generic observations.  Unless you are devoting your life to timing, or paying for a sophisticated service that does, don’t even try.

But if you don’t understand your own strategy and have it written down, you’ll be tempted – and you’ll end up selling at the exact bottom and permanently sitting on your losses.

NOW is the time to write down WHAT you invest in and WHY you do so.  I do it on this blog just to keep myself straight.  You need to do the same kind of thing in a notebook.  Because when your portfolio is bleeding, you’ll need a reminder of what the heck you were trying to accomplish, and your own words of sanity might be the only ones you’ll listen to when the bear calls your name.

Tim