The professional investing world, and students of this world, tend to more-tightly refer to and focus on technical indicators during periods of heightened volatility.
Simply, sudden market ups and downs summon increased analysis, but much of it remains pure speculation.
The last several days are certainly an example of this.
If you’ve read or watched the news, you know the following to be absolutely true:
- The market will crash
- The market will surge
- Nothing will change
- Everything will change
- Some things will change
We, too, are absolutely 100% confident in the above.
Of course, even with all the experts and all their data crunching, no one knows with any certainty what direction the market will go in the short term, nor how it’s going to get there. (Long-term, history shows, the market tends to rise.)
But in the short term, if it does in-fact fall, will it do so abruptly, or slowly? If it rises, will it continue to make new highs and break records?
A big part of the predictive problem is simply due to human behavior and how we interact with one another.
In short, we humans, and our responses to stimuli, are the market variable that drives trends, but which no one can predict.
Ignoring behavioral finance for a moment, some experts believe that fundamental analysis, including:
- Analyzing cash flows
- Profit growth
- And, Book value
are foolproof ways of calculating when the markets have hit bottom.
Others believe that technical analysis, including:
- Analyzing moving averages
- Price trends
- Relative strength
- And, Breadth
are great for identifying market highs.
Our experience has been that both technical and fundamental analysis are useful, but neither toolset functions perfectly all of the time. (They actually work best together.)
Here’s an example of the symbiosis between technical and fundamental analysis: if earnings begin to slow, economic activity starts to decline, valuations appear high, and technical breadth is looking increasingly weak, this may be a time to reduce risk as the market may have a greater probability of either falling or not advancing.
However, what if all technical and fundamental data looks bad, but the economy is showing not only strong growth, but actually accelerating?
Does this mean that technical and fundamental data will likewise follow? Or does it mean that the economic data is stale and will adjust downward?
As mentioned above, there is still the human element to consider. This is why it is so tricky to make outsized bets in one direction or the other.
Let’s take it further.
What about the periods when retail sales are disappointing in the lead-up to the holiday season, but then earnings are much better than anyone expected in the months that follow?
Or how about the times when consumers say they won’t spend much, but then they actually spend a lot? Or when the economy is just starting to really recover, but then massive accounting fraud is discovered at a very large company, hurting consumer confidence and driving down the market?
There are simply too many variables to consider for why stocks and bonds perform the way they do.
While those in the media are always looking for sound bites and justification of how assets are priced, there is rarely a perfect explanation. Some factors (i.e. human nature) simply cannot yet be modeled accurately or consistently. Throw in other influencers, including natural disasters, war, changes in political parties and policies, oil shocks, new technologies, and changing demographics? And you have a recipe that results in a completely different dish every single time. That dish may sometimes taste great, and it may sometimes taste bad. And while you might even love the mystery of it, and make it all the time, you certainly aren’t going to risk serving it at your son’s wedding.
A quick revisit of the technical.
Going back to the technical discussion, the things that industry folks are talking about now are the breaching of the 200-day moving average for the S&P 500 and the amount of breadth of the market.
Analysts usually look at breadth as the percentage of companies leading or falling behind the index and what percentage of the companies are overbought or oversold.
Currently, just 38% of the companies in the Russell 3000 are above the 200-day moving average, which many technicians believe demarks the longer-term trend line. Translated, 62% of companies in the Russell 3000 are trading below the long-term trend line (See Exhibit 1).
Another figure that some cite is the percentage of companies that are trading at overbought or oversold levels. Currently, 27% of the companies in the S&P 500 are trading at oversold levels (as defined as below the 30 level of the 14-day RSI), while zero are trading at overbought levels (above the 70 level of the 14-day RSI).
Just prior to the January sell-off, close to 40% of the companies were considered overbought, while during this last market sell-off, less than 10% of the companies were considered overbought (See Exhibit 2).
Do these figures portend that the markets will crash? Not necessarily. But it could mean below average returns for some time.
Statistics show that when the markets are volatile and when the S&P 500 is trading below its 200-day moving average, that returns trend lower. The data also shows that the market actually performs better when the market is considered overbought than when it is considered oversold. When it comes to trying to time market highs or market lows, it actually almost doesn’t make any difference if you’re going from one 5-year market top to another top versus one 5-year market bottom to another. The difference between accurately timing bottom-to-bottom or top-to-top differentiates only about 1-1.25% from staying invested the whole time. Not only that, but the difference between top to top and bottom to bottom over a 90-year period is just 0.33%!
This means that buying occasionally at the very top and selling occasionally at the very bottom, while not great for your portfolio, may not necessarily ruin your portfolio if you have a very long time horizon. Both the best case scenario, buying lows and selling highs, and the worst case scenario, buying tops and selling bottoms, are virtually impossible without the benefit of hindsight (and time travel!).
However, if your time horizon is short, the chances rise that you will own a significant amount of fixed income, which will help keep drawdowns smaller. The cost of waiting too long on the sidelines (waiting for the bottom) or getting out too quickly (thinking it is the top) may have a bigger impact on the portfolio than not having the perfect entry or exit point.
We don’t like clichés, but your asset allocation and portfolio design matter far more than the next-to-impossible task of timing market highs and lows.
If you’re very close to retiring or drawing income, having a risk profile with more fixed income certainly makes sense. If you have a very long time horizon, or if your investment is earmarked for a very long objective, equities, though volatile at times, are still usually the best option for long-term compounding of returns.
Source: The charts and data referenced here come from Bloomberg.
The S&P 500 Index is a broad based unmanaged index that consists of the common stocks of 500 large capitalization companies, within various industrial sectors, most of which are listed on the New York Stock Exchange. You cannot directly invest in an index.
The Russell 3000 Index is composed of 3000 large U.S. companies, as determined by market capitalization. This portfolio of Securities represents approximately 98% of the investable U.S. equity market. The Russell 3000 Index is comprised of stocks within the Russell 1000 and the Russell 2000 Indices. The index was developed with a base value of 140.00 as of December 31, 1986. You cannot directly invest in an index.
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October 15, 2018
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