There May Be Gains To Capture In Stocks In The Coming Years, But Risk Management May Be Very Important Down The Road

While pondering the recent shift in market sentiment/hard data, along with the possible ramifications for investors, we ran across the quotes below in an October 26 Bloomberg article:

"Central banks are playing catch up with what the market has known for some time - that global growth is slowing," said Jason Daw, head of Asia currency strategy at Societe Generale SA in Singapore.

"While inflation is this low at a global level, central banks will step on the gas again and elevate asset prices for the foreseeable future," Deutsche Bank AG strategist Jim Reid said in a note to clients on Monday. "This leaves a huge gap risk lower for financial markets, but that's more of a problem for when central banks are unable or unwilling to act."

The key takeaways from the quotes above:

1. Central banks may inflate asset prices (again).
2. Every time they inflate asset prices to a new level, risks get higher and higher.

Central Banks Are Not Going Away

Every once in a while someone summarizes the big picture in a simple way. Bill Gross, formally with PIMCO, noted the following in his December 2013 investment outlook:

Don't fight central banks, but be afraid.

Why is this statement so relevant? The market's pricing mechanism is driven by both fundamental and speculative forces. Speculators are not evil; in fact, they provide much needed liquidity for efficient pricing. A healthy market has a relatively even mix between fundamental forces and speculative forces.

Markets that have "excess liquidity" compliments of central banks become skewed toward the speculative end of the spectrum.

Speculative Markets Can Rise For Years

Many will say "I do not want to participate in speculative markets", which seems logical. However, if we told you the stock market was going to rise for two more years, would you want to participate? The logical answer is yes if there is money to be made. Those who lived through the dot-com and housing bubbles can attest to the accuracy of the statement "speculative markets can continue to rise much longer than rational people believe."

2015: The Evidence For A Sustained Rally Has Been Piling Up

Bill's Gross' don't fight, but be afraid comments were published in December 2013, just before the 18% pop in stocks. Are we saying the S&P 500 is about to rally an additional 18%? No, we are saying "they are getting ready to inflate" conditions today are similar to the tone in December 2013. This week's video walks through the evidence that has accrued since the October 2 intraday "key reversal" in stocks, along with an examination of the major shift that helped spark the rally.

We Must Play The Hand We Have Been Dealt

The following statements are reasonable to those who are experienced in the financial markets:

1. Central banks have skewed the market, which means stocks carry higher speculative risk.
2. Markets with a speculative bent can continue to rise for years.
3. All speculative bull markets end with painful bear markets (20% to 50% losses).

Bull Market Could End Tomorrow Or In Two Years

If we know the statements above are true, then it seems logical that we need to account for the following:

1. We have no idea when the current bull market will end.
2. Stocks could rise for two or three more years.
3. When the bear market finally arrives, investors could lose 50%.

Therefore, we need a way to:

1. Monitor the health and sustainability of the bull market.
2. Identify when the odds have shifted to the bearish camp.
3. Migrate from a risk-on to risk-off portfolio as the odds shift.

Monitor and Migrate

Our market model is designed to address needs 1-3 above. When markets peak, it is logical to assume that investor demand for stocks begins to drop relative to (a) more conservative assets, such as bonds, or (b) risk-off assets, such as inverse stock ETFs (aka shorts).

In a world where central banks have skewed the bond market, a fair argument is "stock vs. bond charts won't work this time". While we all know "it is different this time" is a dangerous expression in the markets, let's assume the stock vs. bond charts will not be helpful this time around. The "it's different this time" argument does not hold water when we look at the relative performance of going long stocks vs. shorting stocks. It is mathematically impossible for a long vs. short ratio to "miss a bear market", regardless of what central banks have done.

Long vs. Short: Can It Help Capture Speculative Gains?

The charts below show how monitoring the demand for longs (SPY) vs. shorts (SH) can assist us with managing risk while attempting to profit from a rising, and even speculative, stock market. This video clip describes how the ratio of longs vs. shorts below helped identify the favorable risk-reward environment that existed in 2006 as the S&P 500 gained 17% between point A1 and B1. The short explanation is when the demand for longs is greater than the demand for shorts, it indicates bullish economic conviction is greater than bearish economic conviction. During periods of bullish economic confidence, the ratio below rises, which it did in 2006 when the S&P 500 tacked on 17%.

Can The Ratio Help Us Spot Bearish Trouble?

This video clip describes how the ratio of longs vs. shorts below helped identify the unfavorable risk-reward environment that existed in 2008 as the S&P 500 experienced a 12% loss in June, and another 38% drop in Q4. Unlike 2006, bullish economic conviction in 2008 was clearly lagging economic fear during the periods where the S&P 500 dropped (the ratio was also in a bearish downtrend).

How Does The Ratio Look Today?

The present day version of long vs. short aligns with the bullish case for stocks and "reflation" by central banks.

2015: More Stimulus Coming?

Central banks provide monetary stimulus. The tone of an October 23, 2015 Reuters article is indicative of the recent shift by central bankers:

Stock markets worldwide soared on Friday after China cut interest rates for the fourth time this year and several large-cap U.S. technology companies reported better-than-expected quarterly results...Shares across Asia, Europe and the Americas climbed, having already been boosted by Thursday's message from ECB chief Mario Draghi that the central bank was ready to adjust "the size, composition and duration" of its quantitative easing program..."Draghi has come out and kitchen-sinked the whole thing, everything is now on the table," said Gavin Friend, a strategist at National Australia Bank in London.

Central Banks Need Help From Economy And Earnings

Markets cannot rise forever based on printed money. At some point, the economy needs to carry more weight. Last week, we did see some good news on the fundamental front in the form of strong earnings in the technology sector. From CNBC:

Companies with large cloud computing units surged on better-than-expected earnings as the shift to that storage platform accelerates. Amazon shares traded up 6 percent, Microsoft jumped 10 percent, and Alphabet gained 6 percent Friday. "I think (the cloud) just reflects a secular shift. Every business in the world is going to run on (the) cloud eventually, so we view it as an amazing opportunity," Google CEO Sundar Pichai said on Alphabet's earnings call Thursday, according to a FactSet transcript.

2008: Concepts Helped With Warning

If you think the charts shown above are a form of rear-view mirror analysis, we used the same concepts to post the following warning in February 2008:

"Based on recent technical breakdowns in many risk-based investments, the probability of investors incurring additional losses over an extended period of time has increased. Both the technical and fundamental outlook now favor bearish outcomes over bullish outcomes."

After the February 2008 statement above, the S&P 500 dropped from 1,367 to the March 2009 intraday low of 666 (a decline of 51%).

Investment Implications – Volatility And Flexibility

Since fear is not a strategy, nor can it manage risk, allow us to amend Mr. Gross' summary as follows:

Don't fight central banks, but have a specific exit strategy in place.

One of the most important and difficult tasks for long-term investors: discerning between "volatility to ignore" and "volatility that requires defensive action." If you look at the 2015 long vs. short chart above, it is easy to see things have improved from a risk/reward perspective in recent weeks. Therefore, we will continue to hold our stakes in U.S. stocks (SPY) that have been ratcheted up since the first "growth add" on October 2. Since flexibility is a key tenet of investment success, we must be open to ongoing corrective activity and the possible need for a reduction in our exposure to stocks.

It Has Been A Difficult, Rare, And Frustrating Period

If frustrations are running high, keep in mind that when central banks skew the markets as they have in recent years, some very rare market events can occur as described in detail in this video clip.