Nov 3, 2009: Intermediate-term stabilization

  • 1-month VXX chart showing a reversal-pattern
  • More encouraging signs
  • One possible monkey wrench
  • Rebalancing: if not now then when?
  • Stabilization signs

    The following are merely intermediate-term (roughly 1-week to 8-weeks) observations. Please don't interpret them in any longer or shorter time-frames. They would not make sense if your horizon is much longer or much shorter.

    I'm seeing a confluence of stabilization signs which, after almost 2-weeks of defensiveness, tell me I should "rebalance" my portfolio to the long side again.

    Obligatory comment: There are no guarantees in this art of intermediate-term market timing, and I can always be wrong. This is a game of probabilities and it takes a lot of practice and trial/error to perfect it. I've been wrong before, but I feel that I've been getting better at this game, so I feel more comfortable sticking my neck out. The worst thing that can happen is a another painful lesson which I would use as a learning experience. OK, let's play -- here goes.

    If my hunch is right, then the sharp correction with started almost 2 weeks ago, is either over, or near over. I'm getting more exposed to the long side now and preparing for a nice end-of-year rally.

    A monthly chart of VXX

    VXX (iPath S&P 500 VIX Short-Term Futures ETN) is an instrument which allows investors to get long (or short) volatility.

    VXX is a sort-of inverse-proxy for the markets. Since periods of sharp market drops are associated with investor anxiety and high volatility, VXX normally shows an inverse picture of market sentiment: it tends to peak during intermediate bottoms and trough during intermediate tops. Now it seems to be topping which means the markets seem to be bottoming.

    Take a look at this 1-month (20 trading days) chart. Indeed, VXX has bottomed nearly 2-weeks ago and is now showing a possible pattern of rolling over after getting to an extremely high reading (+2.0 on the Std Error channel) in the monthly chart.

    BTW: I tried to short VXX today and got: "Rejected: sorry, no VXX shares available for shorting" - this is another hint on where the big money already is.

    [click for full-size 146KB image]

    We just had a sharp correction which erased all the gains of the October rally, and part of the gains from the preceding September rally. Investors who heeded the call to be cautious and defensive two weeks ago have avoided a ~5% loss if invested in large caps, and a much more painful 8%-12% if invested in the higher-beta, small-caps or international markets.

    But staying on the short side for too long, might take all of what we gained back, so we should be looking for the tell-tell signs of an impending reversal.

    More encouraging signs

    With VXX/volatility having difficulties making new highs I'm looking for more confirmations. We had many of them today:

    More significant technicals: the volatility of the past few days has been very unusual. To quote Bespoke Investment Group: "Going back to 1928, the S&P 500 has never had a three day sequence where the index broke and closed below its 50-DMA one day, then snapped back and closed more than one percent above the 50-DMA the next day, only to sell off on the third day and close more than 1% below the 50-DMA."

    Such extremes usually mark turning points.

    Looking for the next up-leg leaders: Latin America (ILF) is showing signs of strength with a +1.70% today. Brazil (EWZ), full disclosure: I hold a position, is up +2.04%. IYT (Dow transports) up over 5% on the Berkshire/Buffett news. Ob-Note: it is a bit too late to buy it right now, after such a monster one day move. It is the quintessential short-term overbought case, so I'd wait for a short-term pullback.

    Higher beta stocks, notably financials and some REITs, generally outperformed today. The most encouraging sign was to see the broad, smaller-cap asset-classes significantly outperform their large-cap counterparts. Note that tech which was relatively strong in the past few weeks has lagged today too. That's what reversals are made of.

    PIE's daily scorecard was: up +0.93% vs SPY only +0.32% after losing significantly less than the S&P during the correction.

    One possible monkey wrench

    Can anything derail this view? Yes. There's one unknown biggie waiting in the cards, the labor dept. bureau of labor statistics, Friday unemployment report. It can definitely throw a monkey wrench in the above encouraging picture.

    My hunch (just that) is that a good report will finalize this stabilization with a big relief move up, while a bad one, might push this correction to take another turn for the worse. Being nimble is key in this game.

    Since I'm no Goldman-Sachs or government insider, I don't have early access to such reports and I have to do the best with the tools I have. I can see pretty solid accumulation in many broad ETFs so it is clear where the big money is moving now. I'll keep watching especially late on Thursday. In the mean time, I'd be gradually increasing exposure to the long side on short-term dips.

    The bottom line of all this is, if you didn't participate in the great September and October run ups, now may be the time to get long again, and reposition for a possible end-of-year rally while being ready to reduce exposure once the rally is overdone and tired again like it was 2-weeks ago.

    As always, I may be wrong - but I think that now that the downside risk is much reduced, is the time to "rebalance to the long side" if you will. After the last correction we just had, the upside is there again.

    Rebalancing: if not now, then when?

    When people who (religiously) don't believe in market timing tell me that they do "Buy and Hold" I give up trying to explain my approach.

    But if I happen to talk to a more logical type, the conversation may go like this:

    Them: You cannot time the market.
    Me: Well, you do trade sometime, no?
    Them: Sure, but I never try to time!
    Me: So how do you trade?
    Them: Well, I do asset-allocation to diversify, and I rebalance once a year
    Me: This makes total sense, in fact, I do almost the same...
    Them (after I got their full attention): Really? How so?
    Me: Well, rebalancing means buying the low asset and selling the high asset in the mix. But since arbitrarily rebalancing once a year is pretty sub-optimal, instead of rebalancing once a year, I try to rebalance more often.
    Them: Hmm, interesting... How often?
    Me: I don't have a fixed schedule like "once a year" because fixed schedules are again sub-optimal. I try to rebalance immediately after big intermediate-term moves have occurred, either up or down, it doesn't matter. Essentially, I let the market determine the exact timing.
    Them: This makes total sense? Is there anything else?
    Me: Yes, I also take notice of which assets were the biggest movers within the broader market moves. It makes the results even better.

    You may think as the whole scheme as a triple optimization of the basic rebalancing idea:

    By acting on big moves after they occur, I don't need to second guess the markets. I look at the recent past rather than plain trying to predict the future.

    Big moves like the recent rally and the following correction, tend to occur on a pretty frequent basis. Which means that even sub-optimal moves (not moving in/out at exact bottoms or exact tops) result in

    Avoiding the last correction was worth ~5-10% to a portfolio, for me, this difference is well worth the effort of trying.

    So if you are a cold and calculated "asset-allocator", a good question to ask whenever there's some hesitation to rebalance is: "If not now, after a sharp correction has occurred - then when?"

    As always, I'm not a CFA (Certified Financial Advisor). I'm a student of the markets. This isn't intended as investment advice. It merely reflects my own thinking and actions at the time of writing. In the immortal words of John Maynard Keynes "When the facts change, I change my mind. What do you do, sir?"

    Every investor should make up his own decisions based on his risk tolerance, comfort-zones, time-frame horizons, convictions, and understanding.

    Any feedback is welcome.

    -- ariel