The damage done to markets thus far in January is troubling. Through January 24, the three benchmarks for US (SPY), BigIntl (EFA) and Emerging Markets (EEM) are off 3.14%, 3.35% and 8.51% respectively. Is the Great Bull changing direction?
The following headline appeared today on the DailyMail Online: ‘The world is catching emerging markets flu’: UK and US shares take a hit as plunging currencies worry global investors.
Someone who had allocated 50%, 25% and 25% of their investment portfolio into these diversified products would have lost 4.5% thus far in January. The rankings system outperformed these benchmarks, but the issue of a market reversal should now be a concern.
Asset Class Rankings
A reasonable overview of markets can be obtained by looking at the 11 asset classes routinely followed:
Asset Class Rankings As Of January 24, 2014
These rankings represent substantial change from the beginning of the month and reflect the damage done in January. Only one non-bond asset class ranks above cash (SHY). Surprisingly, that is DBP, precious metals. After horrendous performance last year, this category performed well recently. It is the first time it ranks above the minimum hurdle rate in a year.
More notable is the fact that no equity sector ranks above cash. That could be an ominous warning regarding where markets are going.
Performance
Performance by ranked groupings are shown in the following table:
Through January 24, 2014
| US(6) | BigInt(3) | Emerg(3) | Intl(6) | All(10) | Inflat(3) | Inverse(1) | |
|---|---|---|---|---|---|---|---|
| Selections | -0.89% | -3.59% | -0.73% | -1.49% | -1.32% | -4.14% | 0.11% |
| Benchmark | -3.14% | -3.35% | -8.51% | -5.93% | -4.54% | n/a | n/a |
| Bet/(Worse) | 2.25% | -0.24% | 7.78% | 4.44% | 3.22% | n/a | n/a |
All groupings show losses, although the losses are smaller than the benchmarks. The performance figures assume you bought and held the rankings presented as of December 31. No adjustments are made for stops that might have been executed.
General Comments on Losses
The optimistic way to look at these results is that the rankings outperformed markets. The pessimist would see only that one lost money. The All(10) grouping seems to be the one most used by members. It lost 1.32% while its benchmark was down 4.54%. That is impressive (outperforming by 3%); nevertheless, net worth declined.
It may feel good losing only 10% when the market declines 20%, but it doesn’t feel as good as gaining 10% when the market gained 20%. On a relative performance basis, the two are equivalent. On an absolute performance basis, they are not.
No system or method will make money in down markets (except for those which specialize in going short). What one must hope to do is minimize the losses during down periods and capitalize during up periods. The rankings system did so during the time period just reviewed and showed a propensity to do so over the last seven years.
But what if markets are going to go down further? If market losses are going to continue, it is unlikely you will make money. You may lose less than markets, but you will likely lose. The only way to avoid that is to step aside when markets are going the wrong way. As longer-term members know, that was one of the strengths of this particular trading during the large sell-off in 2008 and 2009.
Momentum trading is trend following. When markets change from one trend to another, the system is unlikely to perform well in the short-term. It has a longer-term orientation than a month or two. Hence, it will not react to small, quick corrections spread over a couple of weeks or a month. It was not designed to behave in that fashion. Such shorter-term systems can be effective, but usually are out-performed by longer trend-trading systems. Furthermore, they involve many more transactions and false signals.
It is too early to determine whether this recent weakness is merely a short-term correction or a major change in trend. You may compare this down period with other down periods in the major uptrend that we are in. A chart of SPY at the end of this article facilitates such a comparison.
The rankings system does not pick up small changes. It is designed to identify major trends.
Current Rankings
Rankings today differ quite a bit from the rankings at the end of December:
As Of January 24, 2014
| US(6) | BigInt(3) | Emerg(3) | Intl(6) | All(10) | Inflat(3) | Inverse(1) |
|---|---|---|---|---|---|---|
| IGN | DLS | FM | DLS | DLS | GLD | DOG |
| IGV | IXJ | FRI | FM | FM | RWR | |
| IHI | SHY | PMNA | FRI | FRI | UNG | |
| IWC | IXJ | IGN | ||||
| VHT | PMNA | IGV | ||||
| XBI | SHY | IHI | ||||
| IXJ | ||||||
| PMNA | ||||||
| VHT | ||||||
| XPH |
These latest rankings can be used as you see fit, although they will not be tracked in performance reports. There is no reason to utilize them unless you want to.
There are a fewl points to be made with respect to these rankings:
- SHY has crept into two of the portfolios above. SHY represents cash and a dilution of funds committed to markets. When SHY appears, it means that not enough ETFs ranked high enough to be considered as buys. It is the ranking system’s way of moving out of markets and into cash. During several months in 2008 and early 2009, no ETFs made the cut. Portfolios were all cash.
- FM and PMNA, both Emerging Market ETFs continue to rank well. Their performance thus far is what saved the Emerging Markets category from showing large losses.
- Both FM and PMNA ranked high enough to make the All(10) rankings.
- GLD has been selected for the first time as a selection in the Inflation Hedge category.
Where To From Here?
It is difficult to make money in declining markets. If you believe that markets are going to continue downward, then lighten up on your positions or get out of equities entirely. I don’t know what is going to happen next week, month or year in markets. We all have opinions. One of mine is that I believe markets are seriously overvalued. Markets operate on their own time and pace. Logic eventually prevails, but it can take much longer than one might anticipate. They can become more seriously overvalued than I believe they already are.
Caution should guide investors because a big move downward appears more probable than its counterpart. But that and a couple of bucks will get you a cup of coffee in a dive not called Starbucks.
I follow the system and let it provide guidance. If I become too nervous, I put ETFs on shorter leashes (i.e., utilize closer stops than normal) or cut back my commitment to the market. Getting out of markets has risks as well, especially in this era of financial repression when traditional fixed income returns have been driven to the floor. Another risk of being out of markets is the exposure to inflation. Stocks provide some protection against inflation unless the inflation becomes very high.
Regarding inflation, it is not high enough (at least as reported by the government) to scare people into inflation hedges. The upward improvement in precious metals might be the beginning sign of that or may just represent market noise. I think it is still premature for most to consider precious metals, although they rank above cash and all equity classes in the latest ranking. It is probably prudent to stay away a bit longer, until the strength is demonstrated for more than one ranking.
I have been and continue to nibble at gold and gold mining stocks outside of the funds committed to the rankings system. If we are headed to high inflation or some type of currency event, these should be a reasonable form of protection. For most people, I think it is still early to begin such a program unless you fully understand the risks. Gold is on the radar of central banks who want to drive it down rather than see it rise.
I have no interest in the Inverse selection at this point. Until the conditions prevail where the system goes to all or nearly all cash, that will likely remain my take.
Some Graphics
SPY (US)
If a picture is worth a thousand words, a graph has to be of value. Here is a graph of SPY. Each bar represents a week and the graph covers seven years. It helps to put into perspective the month-to-date performance as well as the bigger picture.
A line indicates the recent uptrend which began around the end of 2011. All trends end, but there is no reason to buck one unnecessarily. That is especially so for one as strong as this. Note the recent downturn in January. It is barely visible on this graph. Compare it to what seemed like earlier trend changes, say the middle of 2012 or the end of 2012 or the noise toward the latter part of 2013. What we see, so far, in January can only be termed noise. It may develop into more, but that is not apparent at this point.
The three plots below the price plot represent the PPI Indicator(s). The top is PPI ST, the middle PPI LT and the bottom PPI Comp. ST is the short-term version of the indicator. It moves more quickly than LT, the long-term version. PPI Comp is the composite of the other two PPIs. It is the ST values added to the LT values. The composite might be looked at as an intermediate-term indicator.
Note how the long-term and composite versions went and stayed negative for more than a year in the 2008 – 09 period. Note also how they went and stayed positive for the better part of the last two years. A recent test showed how a simple decision rule using this indicator would outperform a buy and hold strategy and do so while not having money at risk for a third of the period.
The short-term indicator, the one that reacts the fastest, has dropped to zero. That could be the beginning of trouble, although that has happened numerous times during this bull market. The LT indicator looks fine at this point. Although the short-term trend is bad, there is not enough information to conclude that the long-term trend has been reversed. The PPI indicator will be used as a supplemental guide to the monthly rankings. Consider it as additional insurance against the downside.
The rankings themselves, under extreme situations, can take us out of markets which they did for parts of the seven years above. The PPI will be used as a front-filter to these rankings. From what I see above regarding SPY, it is premature to do anything but follow the rankings in normal fashion. Perhaps that changes by the end of the month, although that isn’t the case now. Another down week will surely put the ST indicator negative.
EEM (Emerging Markets)
Emerging Markets look very different from SPY. They look extremely risky:
The EEM chart is signaling trouble, likely serious trouble. All the PPI indicators have turned negative. Furthermore, the EEM asset class ranks dead last in the asset class rankings shown above. An asset class can rank low and still have individual ETFs pass the rankings screen. This month is an example of just that situation. Three ETFs in the Emerging Market pool were deemed high enough to be selected.
What does one do in this situation? The class looks terrible, but individual ETFs rank high enough to be selected. My inclination is to avoid all assets in this class until the class itself shows strength. It is possible to make money in a sector that is going down, but it is difficult.
I see no reason to risk money in this space. That includes putting money into FM and PMNA, two ETFs that have performed well recently. The ocean from which we fish is large. Why not fish in places where the fish appear to be more plentiful? By all technical indications that does not appear to be Emerging Markets.
EFA (Big International)
The chart for EFA, not shown, looks similar to SPY but not quite as strong. PPI readings remain OK. The rankings presented above suggest a weakening, as cash was one of the selections. That means a 1/3 less commitment than planned for this sector. It appears OK to go with the rankings at this point.
My only reservation is that economic crises often begin at the periphery where defenses are weakest. Then they spread to the next most vulnerable area. In my opinion, Emerging Markets are the periphery and Europe/Japan the next most vulnerable areas. This consideration will be revisited before making February decisions.
Good luck and good trading.
