Something Strange Is Afoot

Market Correction – Something Strange Is Afoot by Stephen Aust, MarketCycle Wealth Management

In very early 2012, I mentioned to a client that something strange was afoot and that I didn’t understand it.

The bullish period of a market cycle is comprised of three stages with a market correction occurring between each of the stages:

1. Early-stage in which the stock market moves up off of very oversold levels.  Low interest rates cause financial stocks to outperform.
2. Mid-stage in which the stock market begins to stabilize and then deal with slowly rising interest rates.  Technology and consumer cyclical stocks outperform.
3. Late-stage in which inflation rules the day.  Energy and materials as well as dividend stocks and Treasury-bond TIPS tend to outperform

In reality, it is more complex than this with market-cap size and growth or value and even leverage and volatilty taking their respective positions during the total market cycle.

So, what is strange?  As stated above, there is always a market correction of around 20% between each of the market stages.  For the first time, in 2011 as the early-stage was completing, the market went through the entire mid-stage and late-stage in the few months just prior to the resultant 19.5% drop.  As the market picked up again off of the bottom, it went through the first-stage all over again, but it lasted only one month and then correctly entered the mid-stage.  This secondary activity OVERLAPPED the normal market cycle.  It made 2011 look like a “topping formation” that would lead to a bear market… but it was not.  I watched and wondered for the next 4 years until we saw the prolonged 2 year sideways market of 2014 and 2015.  In early 2016, just before the big market dip, the same thing occurred.  The market went through a shortened market cycle in the few months around the market drop; it once again mimicked a false “topping formation.” Very unusual, although we knew from other factors that it was a false alarm… it was not the end of a bull market or the start of a new bull market and there was no coming bear market.  We were correct to hold our attention on the primary market cycle.

Why is this happening?  My conclusion is that:

• It is being caused by hedge funds which are using ETFs to easily rotate through and between assets that were harder to trade before the creation of ETFs (ETFs are Exchange Traded Funds and any asset or bundle of assets can be bought or sold via these financial instruments).  This type of trading is too sophisticated for the typical retail investor to do because they are not in the position to understand complicated market cycle rotations… it has to be hedge funds.  Since hedge funds typically lag “buy & hold” investors in profit gains, this short-term sector rotation isn’t helping them to gain an edge; it is a waste of effort and most hedge funds are still “all hat and no cattle.”  Luckily this activity is not increasing risk either, it is merely increasing choppiness (volatility) in the markets for short periods.

Market Correction – What is the solution?

• Holding assets for longer periods and this gives a sort of time arbitrage where one can simply sidestep the problem entirely.  The entire traditional multi-year market cycle still occurs (see chart below), so we “concentrate on the forest rather than the trees.”
• We stick with our original method of exploiting the entire normal market cycle.  For instance, we are currently in the late-stage of the market cycle.  This final third of the bull market can last from 1 to 4 years.  It is my strongly held opinion that investors should emphasize:  late-stage stock sectors, gold, TIPS, floating-rate bonds and variable-rate preferreds, and low volatility and dividend producing stocks.  AND they should hold onto these positions, without panicking or second guessing, until the next recession begins, regardless of what less patient investors and speculators do.

Is there anything else that can be done to protect against this abnormal and volatile short-term sector rotation?  Yes, absolutely.  MarketCycle splits its stock allocation into four different investing systems and changes investment positions based on the long-term proprietary systems listed below.  All of these systems move to cash or protective assets during recessions.  “Protective assets” could mean anything from Treasury-Bonds to hedged VIX futures or a direct short position in some cases… all of which would create extreme outperformance during recessionary bear markets, and this offers substantial additional diversified protection of the stock portion of client’s accounts.   MarketCycle has, over the years, evolved into using the following four (well tested) systems for stocks:

1. ¼ = changes positions based on the stages of the market cycle (as discussed above)
2. ¼ = changes positions based on interest rate direction and recession chances… positions that benefit from either low or from rising rates while still in a “healthy environment”
3. ¼ = changes positions based on the market cycle as well as relative strength analysis of region and currency strength (relative strength simply shows one assets strength relative to another’s strength… IE, is the U.S. or Japan stronger?) and it also changes in the intermediate-term based on risk levels
4. ¼ = changes positions based on the relative strength of industries and sectors as compared to the strength of Treasury-Bills

Because of the occasional volatile and useless short-term trading of sectors by hedge funds (as discussed above), it is important to use ETFs that can stand alone during any part of the market cycle.  For instance, if an asset (ETF) is selected as the best choice for creating outperformance in the early-stage of the market cycle, it must also have the ability to do as well as the “market” during the mid-stage and late-stage and this way it is less negatively effected by hedge fund and investor caused volatility.

All Charts Below Were Posted Here On July 30, 2016

This chart shows the totality of the current market cycle that started in 2009:

And a closeup view of the past 1.8 years.  Investors now having the ability of trading through the sectors, as talked about above, have likely caused the abnormally extreme volatility that occurred prior to the two bigger dips shown below.  No real problem other than inconvenience and the increasing of investor fear.  The market finally broke out of its sideways trap in July of 2016 and smoother days are ahead.

So, when should we panic?  JUST BEFORE AN ACTUAL RECESSION.  It puzzles me as to why investment professionals cannot determine when a recession is about to hit the markets.  It is possible to do this.  MarketCycle’s calculations indicate that the chance of a recession three months out from today is less than 7%… and risk is currently very low.  As I keep saying:  “We’re still in a bull market.”  There is TONS of money sitting on the sidelines in “cash” and TONS of money sitting in (now) dangerous fixed-rate bonds and this money WILL slowly rotate into stocks over a prolonged period of time and regardless of the occasional recessionary bear market.

As stated above, inflation is the central theme of the late-stage.  This next chart shows the direction of inflation.  This chart is almost too simple to believe.  It just shows “smoothed” economic data (the gyrations were taken out)… inflation started to pick up at the start of 2016; this is a late-stage phenomenon:

Inflation causes inflation loving assets to rise.  Gold is an inflation loving asset; note the timing of its bounce (below) as compared to the direction of inflation (above)…  it happened right on cue, at the start of 2016:

So, what do we do?  Nothing different if we are, like MarketCycle, longer term holders of assets, but it does help to have a possible explanation for some of the recent extra market volatility that occurs just before our expected corrections.  It is just more stupid behavior by people that should know better.  But short-term traders and hedge funds will need to get a grasp on what is happening.  This increased volatility is just another excuse for them to (mostly unprofitably) beat each other up each day in the markets and my guess is that it is ultimately causing them to lose money.  MarketCycle Wealth Management is positioned to patiently exploit their bad behavior for the benefit of our clients.  It has gotten to the point where patience is the ultimate investing technique, a sort of “time arbitrage.”

Thanks for reading!