Stateside: The shadow of the next grizzly

When do bulls age out?  Farmers say the animals lose their virility and social dominance at about six, when it is time to cull them.

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The six-year streak in the S&P 500 also happens to be the longest bull market in American equity history since 1945, with the average having advanced over 800 days without a 10 per cent correction. As the poor old beast gets long in the tooth, investors have grown overly comfortable with the relentless upward direction. Complacency beguiles them, with the false promise that the recent path will also be the future (known to social psychologists as a “recency” bias, whereby humans overweight the importance of the latest events). They take comfort in the faith that “policymakers have their backs,” explains Srinivas Thiruvadanthai, managing director at the Jerome Levy Forecasting Center. At the same time, the low-yield environment puts pressure on managers to take added risks, adding to the one-way momentum.

Death of the bull market

Will it be by a thousand cuts or one sharp blow? All eyes are trained on the Federal Reserve for the first rate move since its last tightening cycle from 2004-2007, when 17 tiny steps brought the federal funds rate from 1 per cent to 5.25 per cent. “How do they extricate from the rate rabbit hole they have climbed down? How do you prevent the dollar from going through the roof and killing all the exporters?” asks portfolio manager Matthew Tuttle of Tuttle Tactical Management.

Kevin Goth, partner at private wealth advisor Snowden Lane, is most concerned about a sharp rise in long-term interest rates in a context of gradual tightening. The Fed can control the short end of the yield curve, but if ten-year rates suddenly spike in a huge bond selloff, will managers exit in an orderly fashion? “The catalyst will be something that happens marketwise and not Fedwise, too fast for the Fed to correct,” he predicts.

Thiruvadanthai agrees that monetary tightening “beyond tokenism,” could undercut the rationale for asset prices, currently propped up by low interest rates. Domestic earnings are already beginning to falter. But he is even more focused on slowing growth in China and emerging markets, noting that every American company announcement and earnings report references weakness abroad. A third of American revenues are already hitched to the rest of the world.

Valuations per se never forecast anything, although they can hint at prospects for the next decade, based on comparative historical norms. Keep an eye at least on rising volatility and somewhat wider bond spreads. Another red flag will be apparent when investors stop buying the market dips, as they did before in May 2013 and January 2014. Guth particularly plans to track rising correlations, as a precursor for a dramatic market drop. Remember how in 2008, all equities moved in panicky lockstep at 90 per cent, rather than rotating across sectors. For now, subdued correlations at about 30 per cent remain in the normal range of 25 per cent to 40 per cent.

Protecting Capital

Return of capital trumps return on capital, so try to stop chasing yield. Opportunities will arise when prices become cheaper. Keep an escape route open, by avoiding illiquid positions. Whether investors choose to employ cash or treasuries ultimately depends on their convictions about the economic forecast, since it takes some stomach to hold the 30-year bond. Alternatively, hedging with options, a classic protective measure, has become more expensive, as fewer banks continue to sell the instruments.

Thiruvadanthai’s currency advice pertains to both US and UK investors: maintain a home bias. Assuming the dollar remains strong, when foreign investments must be converted to greenbacks, they will lose their luster.  Since most large UK companies are really international, again the prescription for UK managers is to avoid non-dollar exposure. In any case, when it is preferable to preserve a close match between living costs and portfolio exposures, sterling becomes the currency of choice for UK managers. 

For investors seeking a one-stop solution, Tuttle has designed an exchange-traded fund, which is programmed for tactical equity exposure throughout the remainder of the current bull market, but to switch to cash or treasuries as it ends. The goal is to remove emotional decision-making by replacing a rules-based approach. Tuttle reminds that bear markets take some time to develop. “Any decent tactical manager could have pulled off 2008 with one hand tied behind their back!” he says. On that principle, his fund uses 11 uncorrelated indicators, based on momentum for the intermediate term, and counter trend for shorter overshoots caused by fear, noise and greed.

For a simpler, back-of-the-envelope strategy, everyone should keep tabs on the 200-day moving average of the market. Or follow the slope of that 200-day curve, noting any pickup in the rate of change. As soon as that indicator starts to head south, beware. In choppy markets, you do risk getting whipsawed, but at least you will be on the right side of history when the old bull finally expires. 

Key Takeaway:

After the 6-year bull run, investors should position themselves for the inevitable bear correction. There are some clear warning signals and protective tactics, and a new ETF designed for market reversals.