The seasonal or annual price pattern for SP500 futures has been upside down for most of this year. Normally, based on 1982 to date, the market tops in February, and it bottoms in October.
The pattern for the DJIA from 1928 to present is similar except for a tendency to double top in February/March and double bottom in September/October.
These are averages of when the market has bottomed and topped, and are useful.
Norman Fosback, building on earlier work by Arthur Merrrill, has cleanly documented in real time that there are smaller periods with the year which correspond to profitable, tradable, rising periods compared to all other patterns. you can read a bit about it at his website http://www.fosback.com/ I won't give away his proprietary and trade-marked method but many of the favorable periods are around month ends and major US holidays. We are in one right now and November and December have several others. Also there are four year and election cycles which you can Google and read about elsewhere.
The sum of all these statistical observations and cycle divinations is that the market should continue up from here. The sceptics and outright bears have all been wrong, and the markets have risen despite all of this and despite sentiment indicators and most certainly despite economic "thought".
I do believe that sentiment is often useful, but not always. This year has been a lot like 1993 or 1995 when volatility subsided or remained low throughout long advances. Also traditional sentiment analyses of stock and index options and futures open interest have not been helpful. These data are double-edged. It is well to remember that large scale buying of short hedges (put options and short futures) often accompanies the buying of stocks by large institutions and can be read as bullish, as are margin debt levels. 1995's do occur!
About a year ago I and several people I know discussed a ten year or decennial pattern wherein the mid part of the decade has a flat high consolidation follwed by a low volatility and very generous bull market. The range bound consolidation lasts one to more than two years before the breakout. Until the breakdown in May I was a big fan of this pattern, but I thought August was too late for it still to be operative. Well it wasn't too late, and the pattern may still be operative. I'll just show you the charts from the 1930's, 1980's 1990's and now, without comment.
Short term I expect a pullback, but it's possible we could see an extension of this low volatility breakout since August.
The SP500 is up ~3.0% since the end of September while my "hedged fund" is up only 0.65% . So I was wrong about the short term expectations of a correction. In fact I have been wrong almost all year, and my total portfolio is up only 6.0% as of Friday. In my own defence, part of my "error" was an experiment in volatility reduction. As often explained here earlier, one can do that partly by selecting funds with histories of low volatility gains by diverse methods, and partly by putting on index hedges . In 2006 the index funds themselves have been leaders as money gravitated back to large caps which are heavily represented in capitilization-weighted market indexes. I have only had the direct hedges since May, and the indexes only began to outperform later in the summer as the new craze for dividends began, but the hedges nearly outperformed the "hedged".
Also in my defense is the fact that my total portfolio never drew down more than 3.25% from any new high value during this year: that despite my still holding some metals and energy positions. So volatility capping has its rewards as well as its costs. The reward largely is "peace of mind" or a low "ulcer index".
I am still looking for a decline during which--hopefully at the end!--I can remove the active index short hedges which have tied up less than 6% of assets but which hedged at a 10% rate due to their leverage. Given the innate hedging of the diversified portfolio, the low volatilty funds largely employed by me, and a good bit of HSGFX from Hussman, additional active hedging with indexes is probably overkill on my part.
So I have proven sufficiently to myself that volatility capping is truly valuable to me but that it can be overdone. Since I will living on the portfolio after transitioning to retirement (unemployment) in a year or so, I needed to reposition and get a feel for these c0ncepts. I think of poor souls with high volatility index funds and stocks who retired at the end of 2000 and saw their equity decline by 20-40% in the first two years of retirement. That is a complete destroyer and a big NO-NO for any investor at that point. And that is exactly where the random walkers like John Bogle are completely wrong.
However, most people reading this page are probably in asset growth mode rather than retirement. So I want to spend some time over the next few months explaining how their portfolio composition and approach needs to be entirely different especially if they are--as they should be-- putting new money in each month, quarter or year. When you are adding new money and automatically reinvesting dividends, volatility is your friend over the long term.
Ten years ago at Kitco, my first internet trader site experience, Glenn Kafka taught me the value of the gold/XAU ratio. I had been a gold futures trader, gold analyst, and publisher for some years, but Kafka's ratio pointed out a new way for me to capitalize on sentiment, which I was just discovering. Gold stock buyers tend to have greater emotional and price swings than gold metal traders. Largely this is due to the fact that a lot of bullion and gold futures players are non-emotional commercial hedgers, both long and short.
In my view, gold is a story of the Kondratieff Wave, but Kafka's method, also backed by John Hussman more recently, is a decent way to capitalize on intermediate term (months to a few years) swings within the decades long Kondratieff Wave bull and bear markets. Whether or not you trade gold stocks or gold bullion or futures, the gold/XAU ratio is a good sentiment measure.
The two charts show the history of the ratio over the past few years. They suggest that gold stocks have not been crushed enough yet to be buys, which in turns says that gold has further down to go at some point.
These charts were made at different times with faciltities available to the public at StockCharts.com, but the ratio ranges are remarkably consistent since the new gold bull market began in 1999.
Another factor that tells me gold stocks or gold are not yet buys is the premium over net asset value (NAV) being paid by buyers of Central Fund of Canada (CEF) which holds gold and silver bullion. As of today the premium is still 7.5%. At the 2005 lows one could buy CEF at a discount to NAV. The chart shows CEF price and NAV going back many years.
John Hussman is an academic economist, and economists do not accept Kondratieff. The Long Wave is simply too long for data frameworks used by economists. But Hussman is also a money manager and has some excellent analysis for tradeable shorter term gold cycles:
Hussman currently is bullish on gold, and has gone to his maximum level of ~20% gold stocks in his Hussman Strategic Total Return (income) Fund. Read his well reasoned approach to gold. We differ in that he is expecting a period of staflation whereas I see a relatively less inflationary interlude in a long term inflationary bull market in which gold has and will continue to be weak for a while. In the longer term I think we both agree that gold will be stronger.
Rich Gates of TFS Capital LLC sent the following comment:
"Have you ever looked at the TFS Market Neutral Fund? Its ticker is TFSMX. It is a no-load product that has a gross exposure of around 166%. Approximately $1.00 long and $0.66 short for every dollar invested in the fund.
Any thoughts would be appreciated."
I did look at long/short funds several years ago, before TFSMX began operations. As I understood long/short funds, they serve the original goals of true hedge funds, namely to buy what's good and sell short what's bad within a given asset class, which for TSFMX is listed stocks. The idea is theoretically sound. However, I was looking for low volatility funds with low costs and excellent long term total return results across several bull and bear markets, and none of the long/short funds I looked at fit those criteria. In addition my experience was that very few investment groups excelled both at buying long and selling short.
Instead what I looked for and found were low cost, low volatility funds with decent longer term records. These funds fell into several groups:
1. Those funds who were positioned long but who reduced volatility and increased returns by raising cash when they percieved the stock market was vulnerable to a spill. Examples I own of this type are First Eagle (formerly SoGen)Global, SGENX or FESGX, and Fairholme Fund, FAIRX. Both of these funds will sometimes hold over 25% of assets in cash. SGENX has 18 year total annualized returns of 14.21%.
2. Those funds who were balanced between stocks and bonds and saw this mission as a committment to being income producers. Vanguard Wellesley Income, VWINX/VWIAX; Dodge and Cox Balanced, DODBX; Berwyn Income, BERIX; and T Rowe Price Capital Appreciation, PRWCX, are all of this type although their names don't always reflect their mission. This year the high dividend fund with reinvestment has become the rage, but the funds mentioned here have always pursued that strategy. Of this group of four, VWINX and BERIX are lower return and much lower volatility funds while DODBX and PRWCX are higher. I own DODBX and VWINX which have total (reinvested) annualized returns of 12.81% and 10.33% over the past 18 years. Over the same period, VFINX, Vanguard's SP500 Index Fund with dividends reinvested has a total return of 11.82%, but VFINX has an "Ulcer Index" ratio over 4 times higher than SGENX or DODBX and nearly six times higher than VWINX! "Ulcer Index" is FastTrack's volatility measure which looks only at downside volatility, since upside volatility is just fine if you are long.
3. Those bond funds which are managed and are looking constantly for safe but higher yields by finding outperforming fixed income vehicles in the US and throughout the world. This is a tall order--safe but higher yields--but a few do it well. I have not covered this group at this site, and want to do so later, so I will only mention one I own: Loomis Sayles Bond Fund, LSBDX/LSBRX. They have been operating only since 1991 and their annualized total return is 11.41%.
4. Hedged, as opposed to "hedge funds". Hussman Growth Fund is the best of these according to my criteria above. They have returned 12.48% annualized over the past six years. From their inception in 2000 to April 2004 their return was 19.4% annualized given their hedged stance during the bear market which was a giant plus. Then they started getting relatively unhedged in late 2002 and caught the 2003-2004 impulse wave. Since April 2004 they have been quite hedged again which has cost them dearly, and their annualized return since April 1, 2004 is only 3.9% while Vanguard's Prime Money Market Fund has returned 3.0% for the same period! Hedging is like insurance and it has a cost, as I have discussed before.
These four types of funds are the core of my portfolio, augmented by small positions in more volatile sector or niche funds which have good returns adjusted for volatility. I use FastTrack's UPI measure which ranks funds returns compared to its own Ulcer Index and the return and volatility of a low risk benchmark.
Looking at TFSMX and some of these other funds since September 14, 2004, the first date for whgich I have TFSMX data, TFSMX has returned 10.54% compared to 10.35% for Vanguard's SP500 Index Fund, VFINX, but at only 2/3 the Ulcer Index rating. This is good. However, TFSMX's Ulcer Index was 70% higher than the average of the Core Funds I own. FAIRX and SGENX have slightly higher Ulcer Index ratings than TFSMX but have nearly twice the UPI adjusted returns. And TFSMX, despite being net long ($1.00 long and $0.66 short for every dollar in the fund) has done relatively poorly over the past two months when stocks rose compared to the other funds. Whether this is due to poor stock selection or hedging costs isn't clear, but TFSMX is down 2% (12% annualized) while VFINX is up 4.51% (27% annualized) for two months through yesterday. TFSMX collapsed in the first two weeks of September at an annualized rate of -61% while VFINX was up at a +23% annualized rate. TFSMX is low cost compared to hedge funds, and it is no-load, but at ~2.5% per year for expenses it is far above Vanguard's VWINX (0.24%) or Hussman's HSGFX (1.1%).
The big drawback for TFS Capital LLC is their short two year history. This has been a very mushy period for the stock market since March 2004: a bull market of sorts but not raging, and not a bear market either. We simply cannot gauge how TFSMX will do in a real bear or bull market, and the career histories of the firm's principals give us no hints. They have made a good beginning, and I am intrigued by their fund but not buying it at this time. And as you know I make no recommendations and do research only for my own and family accounts.
The daily sentiment oscillator made three more > +15 readings this past week, and the 2CS sentimeter fell under 50 again. The major indices crept upward, but the Russell 2000 (RUT) gave back nearly all its gains of the week fom the Thursday high open to Friday's close.
My short hedging has cost me some opportunity profits, about seven tenths of one percent of assets, which I regard as not excessive. I am keeping them in place.
The timer lines have given nice short term turns but nothing like a swing trade since May. There was another sell signal one for Friday, so we shall see. Two timing gurus I respect and have mentioned in these pages have important turns for October. One of them thinks it will be a top lasting into next year at least, and the other thinks it will be a low leading to highs in 2010. Obviously at least one of them will be wrong!
At times like these the temptation is there to throw all timing and sentiment indicators out the window and "Just Buy" as a friend says jokingly. Added to that is Michael Covel's "Trend Following: How Great Traders Make Millions In Up or Down Markets" which another friend recently sent to our house. Covel's book doesn't tell you how to follow trends, just lots of evidence that many of the greatest traders of the past 25 years have been trend traders who used rule-based systems. Nevertheless, I bought health insurance for the market with my hedges, and I shouldn't be angry because the market chose not to become ill. Yet.
I'm sticking with my own "rule-based" system which says not to buy when sentiment is at the high edge where prices have faltered over the past decade.