What’s So “Golden” About the Current Market Environment?

Gold recently traded to a new closing high, at $1,238 an ounce. In the process, it took out prior technical resistance, and was accompanied by decent trading volume. That prompted a discussion here about the yellow metal this past Wednesday. We’ve held gold in our portfolios for some time as both insurance for a wide array of negative scenarios (hyper inflation, systemic crises, terrorism, currency debasement, etc), as well as the potential for a mania to develop in this asset class over time. Gold hasn’t always worked for us against our benchmark, due to its low correlation to equities, which can make relative performance versus equities very fickle at times (one of the things we like from a diversification and hedging point of view, but hate when it costs us versus our benchmarks).

In our Wednesday meeting we took a few minutes to talk about what was driving gold’s impressive performance of late. In other words, is this a breakout or a fake-out that we are witnessing in the gold market, and what does it mean to us? Should we sell into the rally, pile into the momentum trade, or do nothing at all?

The chart below gives a glimpse into a number of the key issues we discussed at the meeting. At the end of the discussion we decided to leave our positions in place and take no action at this time. If you are a client in Pinnacle portfolios, while we ended up not making a change to our allocations, rest assured that it wasn’t because we weren’t watching or talking about the potentially golden opportunities that moving markets create for our clients.

Euro At A Critical Spot

In the wake of the massive, $1 trillion bailout package concocted by the European Union, IMF, and European Central Bank last weekend, conventional wisdom was that the euro would get a big boost. After all, it had fallen by more than 16% percent since the news of Greece’s budget problems first surfaced late last year. However, after a brief reprieve during the trading day on Monday, the euro has rolled over and fallen back down near the lows from last Thursday (currently trading at $1.26 - see chart below).

The lows around $1.23 - $1.25 from late 2008 and early 2009 are critically important. If the euro breaks lower than that, bearish investors may pile in more than they already have, driving the currency even lower, perhaps back towards parity with the U.S. dollar. That would be a crushing defeat for European leaders, since the recent bailout package was designed as a “shock & awe” attempt to save the currency and remove growing doubts about the ultimate survival of the European Monetary Union. A fresh drop in the currency would reignite fears of contagion and de-stabilization, likely leading to another bout of volatility in the financial markets.

Mr. Miyagi and Trading Corrections in Cyclical Markets

My wife is usually in charge of the gardening at our house this time of year, but for some reason I thought I would pitch in this spring and help plant the annuals. I thought that gardening would be like Mr. Miyagi in the movie Karate Kid, where Pat Morita’s character studiously and artistically trims his ornamental bushes in a way that has Zen Master written all over it. I thought of great men like Winston Churchill puttering with their plants in the shade in between tea times and creating art. And so it was for me…at first. I cherished each of the annuals that I planted and took the time to consider each of them as individuals, a blessing of nature, a soother of souls. But then my wife explained that we needed to move the rest of the lariope (a plant that spreads all over the place) that was taking over our flower bed. All of the sudden gardening turned into back breaking work. It was hot. The lariope have a maddening network of roots that is impossible to dig out. I’m sure Mr. Miyagi would have paid to have someone else pull his lariope if he had any.

Investing a correction in a cyclical bull market is much like moving the lariope. You might think that the decision to take profits is made where analysts armed with the facts easily discern the right trade to make and the right timing for the trade. The trade gets executed, the markets react right on cue, the analysts look knowingly at each other having once again outwitted the consensus of investors, and all is right in the world. But timing a correction in a cyclical bull market is often like pulling the lariope from the garden. Oh brother it’s hard work. The facts are maddeningly confusing, the risks look similar on both sides of a trade, and the market proceeds to do something you had discussed the day before but decided not to invest. When the market corrections are less than 10% from top to bottom, resulting is rather small portfolio losses, you work twice as hard as you do otherwise and it often doesn’t result in any transactions in the portfolio. You just grind it out. When the markets get like this you have the usual research to read, more than the usual number of team meetings, as well as a river of special reports on topical subjects. As you might guess, just about everyone has something to say about the recent troubles in Greece. I can’t wait to start reading about oil spills…I know it’s coming soon.

So the lariope have been transplanted and the beds are ready for more annuals. Linda (wife) tells me that this is the work that has to get done before you can really enjoy the beauty of the annuals that you plant now for the enjoyment of your summer. Last week’s market turbulence resulted in some seemingly well-timed selling of our U.S. Treasury Bond positions and buying of an Industrial sector ETF. In the very short run our work has been rewarded. Beyond that, I believe that the work we are doing in the investment team today will result in significant outperformance as the year progresses. Then I will stand back, like Mr. Miyagi, and admire our handiwork. Ahh, Daniel-san…..Hiyaahhhh!

Technical Damage Contained So Far

Prior to the recent sell-off, we’d repeatedly referenced how strong the underlying technical condition of the market was. We regularly monitor a variety of these different price-based measures, and prior to yesterday, we didn’t see any of the classic divergences that have preceded significant market declines in the past.

While yesterday’s rout was certainly nerve-wracking, it appears that technical damage was relatively contained on most measures. At one point, the S&P 500 broke below its longer-term 200-day moving average. However, it managed to finish above that level by the end of the day. Other measures like advance/decline lines and new 52-week lows were moderately worse on the day, but don't appear to be flashing alarming warning signals at this point.

There were a couple of measures that suggest that there may have been too much fear in the market yesterday – total volume on the NYSE reached 11.4 billion shares, very close to the levels hit in the fall of 2008, just after the collapse of Lehman Brothers, and about a year into a bear market that had already seen a 20%+ decline in stocks! In addition, the VIX Index, which measures the volatility of options prices and is widely viewed as a “fear” indicator, rose to 41, which was the highest level since last May, almost exactly a year ago.

In short, while there may be more volatility ahead as the Greek crisis continues to capture headlines, we believe yesterday’s sell-off may have been overdone, and are staying the course for now.

Chart: NYSE Total Composite Volume

Chance Favors the Prepared

Recently our investment team has been discussing the possibiity for a cyclical bull market correction, and preparing ourselves for the waters to get temporarily choppy. The thought was that sentiment had gotten frothy and that many positions were way extended over the 200 day moving average. Heck we’d only had two major corrections during this huge run in the market, and they were about 7-8% in magnitude. In our models we created different strategies we might pursue if the correction unfolded. For our very aggressive clients we were preemptive and pulled about 10% of equity positions out of the portfolio on April 29th. For models with less risk, we planned sales of treasuries and potential equity buys to augment exposure on a dip.

The 200 day moving average seemed to represent a good target for the correction we were looking for, since it’s the long term moving average and should represent major support. Coming into today we were still 6% off that mark and eyeing up the possibility that we might start to nibble as we approached the long term moving average. What we didn’t realize was that the market was about to fall right through the 200 day moving average in one day.

The markets started down on riots in Greece, oil spill angst, and a surprise that the ECB has not yet considered quantitative easing. Things looked orderly through midday, but at about 2:00 things began to accelerate as computer selling kicked in. Then, at about 2:45, the market simply imploded, as the S&P 500 dropped by about 50 points in 5 minutes, and was down by about 100 points on the day (below the 200 day moving average at that point)!!

With a mini panic on, we quickly went into action, and Sean Dillon calmly executed some sales of bond positions that were rallying hard (5+% at one point in the TLT) on the fear present in the markets. We also had planned to begin buying back some high volatility positions in our most aggressive models, and were able to buy a high yield ETF that had plummeted 7% during the malaise. It turned out that the most precipitous part of the drop was due to a trader error and markets quickly rocketed back off the lows, eventually closing the day back over the 200 day moving average and 37 points down on the S&P 500.

Years ago Louis Pasteur said that chance favors the prepared. In this case, our forward thinking strategy and ability to execute in a nimble fashion prepared us to execute trades that dropped right into our lap.

Oil Slick or Economic Problem

Recently, one of our clients forwarded us a piece about the Gulf oil spill and its possible economic and financial ramifications. In the piece, written by well known analyst David Kotok of Cumberland Advisors (http://www.ritholtz.com/blog/2010/05/oil-slickonomics/), Kotok paints a picture that this oil spill will create a financial calamity for many businesses, making a double-dip recession more likely.

Personally, I hate this spill, and am sorry that wildlife and human life has to suffer due to the accident. But I think that turning this unfortunate accident into a higher probability for a double-dip may be a little too drastic at present.

Recent articles about the cumulative economic damage resulting from the spill brings me back to articles that circulated back when Hurricane Katrina rocked the Gulf region back in August of 2005. At the time, there were scary headlines about the ultimate impact of the hurricane on GDP growth and financial markets. Though there was some volatility in the S&P 500 around the time of the storm, patient investors who didn’t panic were well rewarded, as the market rebounded with a gain of about 24% off the October 2005 bottom.

There’s no guarantee that this spill won’t turn into a real problem for growth and financial markets. But for my money, I’d worry more about continued problems in the Euro-zone, falling money supply, depressed wages, and the winding down of the "grand experiment" of massive fiscal and monetary stimulus. In that regard, we’ll continue to diligently monitor macro fundamentals, technical analysis, and valuation, looking for cracks in the bull market.

At present, we still believe that the higher probability is that this is simply a temporary setback. It’s certainly scary, as market corrections always are. But rather than focus on what could go wrong, we are currently focusing on how we can use this bout of volatility to add value to our portfolios.

Shooting the Winners

Last week, the investment team met for several hours and one of the main topics of conversation was the extended condition of several sectors of the stock market. We have seen this before during the past thirteen months. The S&P 500 Index will get more than 10% above its long-term 200 day moving average and then correct about 8% over a period of several weeks, and then go on to make new highs. The most volatile (highest beta) cyclical sectors will correct closer to 20% during these brief episodes, and then reward patient investors by once again leading the market higher. There is no doubt that financials, consumer discretionary, industrials, and materials have been the market leaders in this raging bull market environment.

At our meeting, we specifically considered either trimming or selling outright the consumer discretionary sector, which has confounded analysts concerned about high unemployment and weak residential real estate prices, by having some of the strongest earnings gains of all S&P sectors. On one hand, it seems to make sense to sell the leaders after a strong run to buy a lagging sector, the idea being that the leaders will mean-revert to more average returns and the laggards will catch up. On the other hand, it is a well known rule in the investment world that one of the biggest mistakes that you can make is not to let your winners run. Lots of money has been left on the table by investors who took their profits too early. Confusing the situation even further is our basic outlook which calls for the market to continue to work its way higher during the year, although we are aware that we are entering the worst seasonal part of the year to invest (“Sell in May and go away).”

For me, the most important question is whether or not we should couple taking some profits from a winning security with the notion that we can defend against a market correction that is due to appear any day now. We are 1 for 2 during this bull market in timing these short-term dips in market value. Our conservative and moderate portfolios would only decline 3% to 5% if the S&P 500 retreats to its 200-day moving average. I’m not sure that is significant enough to worry about. As of today we decided not to take our winners out and shoot them, but we are continuing to look at this trade. Perhaps the Greek fiasco will be the catalyst for the next correction and we will shortly be discussing buying the dip, instead of shooting the winners.