Despite the market uptick in the last few days, the asset allocation model (https://onthemarkinvesting.com/otm-asset-allocation/) still strongly favors bonds over stocks. It is predetermined to err on the side of protecting assets against substantial market drops. You can expect it to slowly rationalize to a new steady state value as the weeks go by. This rebound in the market is not completely convincing, yet. Technically the pierced long term trend lines have not been collectively passed on the upside for at least 3 days or by 3%. The model itself continues to register “BUY” in the long term, but not yet in the intermediate or short term. As a longer term investor, you may need to see some stability and direction in the market before you put many of your cards back on the table. Or at least a “BUY” signal in the intermediate term S&P. Another point of reference is the Russell 2000. The index has still not recovered (see below) from the most recent drop, and still does not register BUY on either the intermediate term or long term. Remember that the Russell typically leads the S&P. It is leading it up in the short term, but the strength does not appear yet to rebound back to previous levels. It is a fact that long term bonds are still favored by the market and by the technical model (see below). This despite poor bond returns, fear of eventual inflation, and a VIX (fear index) gauge that at 16 is now back below the historical average of 20. Between earnings season, general elections, and Ebola we have enough triggers to move the market around. This is a time of short term “static” and financial news chatter. If you are a longer term investor, stay away from the headlines and watch the numbers. Make sure your assets are allocated between the asset classes (stocks, bonds, real estate, …) in a way that you are comfortable with. If this is a “traditional” 4Q then stocks will be strong, the trends will continue past broken lines, and we will resume the bull market. But until then, stay alert.
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The S&P 500 has “corrected” 6.6% since its high on September 19. So what is next, and what to do about it? Here is a suggested order of analysis: 1) First, asset allocation. The asset allocation model presently recommends a split of 59% Bonds / 28% Stocks / 13% Optional. Traditionally these splits don’t move too much week to week. In fact I would check them a) weekly only, and b) just move monies to stay in sync if I was out of whack more than 5% (500 basis points). You can see from the chart below that this “inversion” of the stock/bond percent spread has happened several times in the past few years. 2) Secondly, note that the S&P is still a long term BUY in the technical model. It is however not a BUY in the intermediate or short term ranges. The 4Q of the year is traditionally a good time for the market, and I would not be surprised to see another upward move. But…..on technical grounds (and you can see this in the charts below as well), two very long and important support trend lines have been violated. There is speculation that this violation is part of the reason for the drop and the volatility. Trend lines tend to become resistance when they are violated, so….my working hypothesis is that we are not going to see a big uptick in the market in the near term. In fact we may not be done in the current correction cycle. 3) On October 5 I mentioned that small-cap stocks often “lead the charge”. The Russell 2000 has not begun to recover. In fact it went down again on Friday. So…I would advise to get your target asset allocation where you want it — always. But as the numbers above indicate, you may want to hedge this market a bit. If the S&P reverses course and rises again, you can join the fun later. But it is as likely that we are not done yet on the downside.
Unfortunately last week’s warning that trouble may afoot in the market (https://onthemarkinvesting.com/otm-investing-market-update-oct-5-2014-trouble-in-the-air/) proved to be accurate as S&P dropped 3.1% last week. As you can see below, the S&P index has violated two of the three long term logarithmic trend lines; the line most recently violated goes back three years. The technical model itself has SELL status for both short and medium term. And the OTM Asset Allocation model (https://onthemarkinvesting.com/otm-asset-allocation/) has shifted to equal weighting for stocks and bonds, which is an 800 basis point drop in stock weighting over the week. So what now? 1) Don’t panic. We’ve had around 12 of these downside adjustments since 2009. This is not necessarily the beginning of a major correction. 2) Do pay attention to your asset allocation. If you have 50%+ of your assets in stocks, you may wish to dial that back to a 50-50 mix of stocks and bonds. 3) Do pay attention to the S&P. If it drops below 1850 (another 3% drop) it will violate the last of the long term trend lines. And likely this will also trigger a long term SELL in the model. And it would likely trigger an inversion of the asset allocation model toward bonds over stocks. However what is just as likely to happen is that the market will take a breather, absorb this 12th correction since 2009, and continue its upward trek. Either way, make sure you know what your plan is.
If you just look at the S&P 500 chart, you’ll see some volatility but no violation (yet) of long term trend lines. However, the Russell 2000 begs to disagree, and that is significant. The Russell 2000 is an index composed of the 2000 largest “small cap” stocks. While it is far more securities than the 500 in the S&P 500, the total capitalization of Russell 2000 companies is only 10% of the S&P 500 large cap stocks. Historically, small caps lead large caps, both up and down. And that is where the concern lies. The chart below is a four year picture of the Russell 2000. The index has dropped below its long term trend line. It is SELL on all three technical models. And the index is right at the neck of a head and shoulders pattern, which technically is a strong indication of a meaningful change in direction. Looking at the Russell 2000 over the more recent, shorter period, you can see the peril in the indicator. The S&P 500 has yet to violate the long term trend lines that I pointed out last week. But the increased volatility of the near term, coupled with the “divergence” of the Russell compared to the S&P, does raise a number of very serious questions about the strength of the current rally. Small companies have fallen — will large companies follow suit? Conclusion: Keep a very close eye on the S&P over the next week or two. We’ll let the models take us where they take us. But increased scrutiny is warranted.
The overall technical model still shows a positive view on the S&P500 for the intermediate and long terms. As you can also see, there are three resistance lines ranging in age from 1 to 5 years that have yet to be pierced. As the asset allocation page shows, it is still wise to remain in market index ETFs and funds. No need to shift your assets to cash or bonds as a hedge for the intermediate or long term.