This is a time of year when people feel compelled to make annual forecasts. If the past two years have taught us anything (that we should have known anyway), the market will do what it wants and then some. An old adage that I have found useful is that the market does whatever will hurt the most people the most. While I would like to think that the market is a bit friendlier than that, the truth is that the market is unpredictable. Good investors know that the key to success is capital preservation during challenging markets and a willingness to take risk when appropriate.
So, is now a "challenging market" or an "appropriate time to take risk"? While I don't believe that we are necessarily at the end of this rally, I still characterize the market as a bear market or at least still a transitional market. It is certainly not a buy and hold market. I know that it's subject to a lot of debate, but it shouldn't be so hard to characterize the long-term trend in the market. While it's not really my point in this article, the economy continues to suffer from structural challenges that should take years to resolve. Any efforts to avoid the cure (extended slow growth so that balance sheets can be repaired) by our government or the Fed risk a multitude of other problems. Maybe this doesn't kill the market, but it should keep returns constrained.
When I try to characterize the market, I look at the S&P 500, as it is the bulk of the market. Yes, though I sure spend almost all of my time looking for opportunities across a larger set (i.e. small-cap), the fact is that most people, by definition, have most of their money in the S&P 500 since it represents such a large part of the overall market. The S&P 500 had a huge bull move into the end of the century and then what was a normal bear market. It was followed by a run at the old high, but it was goosed by very easy money. This past move down was not a normal bear market:
How do we characterize the recovery? One thing to look for would be taking out old support, and we aren't there yet in my view. A better method, though, in my experience, is to discuss Fibonacci Retracements. If you aren't familiar with the concept or the thinking behind it, I urge you to investigate it. Retracements typically will be a minimum of 38.2% to a maximum of 61.8% (though that is not exactly correct - there are higher retracements). The thinking, then, would be that if the market recovers 62% of its decline, then we must be in a new trend. At this point, looking at the peak in 2007 to the trough in March of 2009, the market has recovered 52.6% of its decline. If you are bearish (which I am not for now), that isn't good news, as it could (and probably will!) rally another 7% or so. 1229 is the next real definitional test in my view. Take a look at a daily chart or weekly chart that goes back into 2008 and you will see that there is a lot of old support around that level too.
Now some technically inclined pundits (I am not one of those - I am a stock picker) are pointing to the retracement in the NASDAQ, which has clearly exceeded the 61.8% retracement thanks to its composition that favors growth sectors relative to Financials. I don't see this necessarily as a harbinger for the whole market. It's ROTATION! Heck, even this week we saw people fly into the lowly Financials, which are for now the best sector on the year. The elixer of easy money (low interest rates and a soaring market) is bringing back the casino mentality that has gotten us where we are to begin with. But I digress...
To look deeper into what's going on, I wanted to look at the sectors that comprise the S&P 500. There are 10 of them, and there are ETFs for all but one (I substituted a very close one for Telecommunications). As you can see in the graphic below, 3 of the 10 sectors are above the 61.8% recovery, while 4 have yet to recover even 1/2:
My takeaway is that certain parts of the market may seem to be in a bull market because of their recoveries, but the overall market has a challenge ahead. Let's see if it can take out all that resistance 7-10% above here.
For now, I have my model portfolios positioned rather interestingly. The Top 20 Model Portfolio, which by design is always pretty much fully invested, has no Energy or Tech exposure. It is heavy in Health, Consumer Discretionary and Industrials. Almost all the names are small-cap. The portfolio holds several positions that I would characterize as deep value and/or contrarian. My Conservative Growth/Balanced Model Portfolio, which allows me some flexiblity in asset allocation, is just under its 60% targeted equity exposure, well under its 40% bond exposure and, thus, a bit heavy in cash. The stocks there are smaller than typical for the S&P 500. In aggregate, we match the S&P 500 dividend yield but we do so with signficantly better balance sheets (almost all names have net cash). The foundation I manage has a 60/40 mandate too, but it isn't necessarily "conservative". It pretty much looks like the Top 20, with equity exposure at 72% (the maximum I allow is 75%) and bonds at about 20%. I expect to be reducing equity exposure in the coming weeks.
Disclosure: No stocks mentioned
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