Time To Hedge Long-Term Core Equity Exposure

Major US equity indexes all entered in all-time high territory last year. That in itself was a very bullish indication, as it showed the past of least resistance still remains to the upside. Last month, everyone on twitter, financial newspapers, market news websites was celebrating the fifth year anniversary of the current bull market, and let’s face it, market sentiment seems very bullish today… maybe too complacent?

To answer this question, let’s review some of the technical, internal and sentimental perspectives of the current bull market...

I first want to tackle the "too complacent" argument that a lot of market commentators - mainly from the contrarian or perma-bear category (think ZeroHedge) - bring to the table since early 2013 to predict the theoretical impending stock market crash. Even if the argument can seem logical, orderflow traders understand that a very bullish sentiment is not enough to predict a market down turn, even less a market crash. “The Market can stay irrational longer than you can stay solvent” as John Maynard Keynes is known to comment. I agree that sentiment extremes are important warning signal for traders. What many contrarians fail to understand is without any catalyst or reason for the sentiment state to be shaken, the turn will never happen by and of itself.

That’s the reason why many missed the 2013 rally, afraid by the extreme bullish sentiment signals provided by indicators like NAAIM & AAII surveys*. Take a look at the three failed sell signals in the chart below (blue circles). Those contrarians were blind to the major sentiment driver that was QE3, which along precedent FED monetary stimulus launch (QE1, QE2, OT), was a strong bullish signal for risky assets. As the old Wall Street adage goes: “Never fight the FED”.

Then, let’s now review the other sell signals, the two most successful ones. It is important to note that they both coincided with “changes in the rules of the game” (George Soros quote) via the end of QE1 in 2010 and QE2 in 2011. Those signals predicted the two major corrections (-17% and -19% respectively) of the current bull market. You will notice the similarity with current conditions where we will see the end of QE3 in the next few months (around September 2014 per consensus projections). Will history repeat or this time is different?

If you remember from my previous article on market cycles, seasonality is very challenging for stocks in 2014, and some other technical indicators are pointing out to weaknesses. For example, see the below S&P500 monthly chart. The RSI is showing a bearish divergence in overbought territory, a strong TA warning similar to what occurred at both 2001 and 2007 tops.

Looking at the shorter time frame, we can see one more bearish divergence on the daily RSI indicator as well as on the On-Balance-Volume (OBV). The price is building a rectangle consolidation pattern in a kind of rounding top, two well-known distribution chart patterns. This information, combined with confirming volume behaviour (increasing on down days) and yesterday bearish close below the rectangle support and the 50 DMA are more technical damages that warn we are close to seeing a top.

Finally, an interesting phenomenon is happening in terms of sectors rotation. It is clear that market participants are turning to a less aggressive risk taking stance. Take a look at how money flows from risky cyclical stocks (XLY) into safer, more defensive sectors like utilities and consumer staples (XLP, XLU) in the chart below.

Seasonal, technical, internal and sentimental evidences are too many warnings for me not to turn more cautious. 

Let me be clear here, I am a trend follower. As such, I will paraphrase the old Mr Patridge from "Reminiscence of a stock operator":  Well, you know this is a bull market!

I am not saying we are seeing the final top of the current five years bull run. I have many reasons to think it is not (that goes from fundamental to market breadth analysis) and I will cover them in my next article, but the main one is I always assume a trend will continue until proven otherwise. Top and bottom picking is the game of uninformed, loosing traders, and I recommend to play the downside only after a Dow bear market signal. Furthermore, US equities is the best asset class performer and as such I strongly advise being exposed to it. 

That being said I can easily see the market offer future buying opportunities at better prices for the many reasons presented above. An easing to the first obvious support zone near 1730 and maybe deeper into the very big support 1550 (old all-time high and 38% Fibonacci retracement of the current 2,5 years up-leg) will offer such opportunities.

That is why I would also advice in the meantime buying protection through the acquisition of puts. We all buy fire insurance and hope it is never needed.  I’m suggesting the same today for your stock exposure.

*NAAIM member firms are asked to provide a number which represents their overall equity exposure at market close on a specific day each week. Responses are processed to provide the average short (or long) position of all NAAIM managers as a group. The responses can range from 200% fully leveraged short to 200% fully leveraged long position.

The AAII Sentiment Survey is a weekly survey of its members which asks if they are "Bullish," "Bearish," or "Neutral" on the stock market over the next six months. AAII first conducted this survey in 1987 via standard mail. In 2000, the survey was moved to AAII's website.

RPS: Sell signals are generated when the two surveys indicate complacency.

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Cycles Within Cycles

Seeing how investors psychology affect all security prices through the boom/burst cycle of optimism and fear, technical analysts are devoting an entire field using cycles theory to predict this repeated pattern. Similar to natural scientists, they identify reliable temporal patterns and cycles that have stood the test of time. I would like to review those cycles in this article, but first I need to warn that this analysis is not something to depend stricly upon, for the simple fact that they are not as strong order flow generators as macro factors can be for example. That being said they are consistent enough to be considered by technical analysts when they time long-term investments, so I still find interesting to look at them.

The longest cycle I want to review is the well-known Kondratieff or K-wave cycle. A large academic body of knowledge is attached to this theory, but even if it is an intellectually stimulating topic, it is not really actionable. It is too long in duration to be important for trading purposes, averaging around 60 years in time, but more importantly have not enough history to be statistically relevant. It is also vital to understand that not every researchers agree on the dates of peaks and troughs. An acceptable dating is the one proposed by George Modelski and William Thompson which validate the last troughs in 1792, 1850, 1914 and 1973. The next projected low is expected around 2020/25 which confirm the projections of the US birthrate theory that project it in 2020. In fact researchers have found a strong correlation between the stock market and US birthrate advanced 45 years:

Next come the famous secular trend which last for about 34 years, a 17 year period of dormancy followed by a 17 year period of intensity. I say famous because I believe it is the most popular cycle that analysts are refering to in the common media. It is statistically more reliable than the Kondratieff one, and it is interesting to note that commodities are also linked to this cycle as when stocks go through the dormancy period, commodities rallies and vice versa. The next major low projected by this cycle come around 2017-18. (I would likely review this cycle in latter articles because many interesting studies and theories revolve around it).

Next come an important part of cycle analysis that is referred to by technical analysts as seasonality. 

Taking a look at the decennial pattern, commonly use due to the price tendency in the stock market to have similar characteristics every ten years, it appears clearly how this decay is following its predecessors pattern. It is important to remember when studying seasonality that direction is more important than levels. True, this decay start is better than its historical averages and can even be consider a little overbought, but the direction seems to be repeated again. Interestingly enough, if the pattern continue to fit past history, this uptrend will continue until August 2017. I would like you to notice that it is also predicting some kind of range trading this year that fit with the presidential pattern, our next topic. 

The presidential cycle is likely the most well-known temporal pattern in the market today. It is reliable and backed by many studies on a long enough time span to be  classified as statistically relevant. This pattern is signaling a correction for the stock market in 2014 from mid-April to the start of October. I find very interesting the fact that it fits with the range trading we identified on the decennial pattern. After this unfavorable time passed, stocks are forecasted to rally until the next election in November 2016. When the next presidential cycle first two years under performance kicks-in this will be in agreement with the slightly up but still flatish end of decay usual average.  

Putting all the pieces together, we can summarize that following technical analysts cycle theories, stock market should keep the uptrend ongoing till the next presidential election after this year dangerous time window has passed. The end of this decay should then produce a major low for stocks that is in line with the secular and Kondratieff projections, ence the title of this post: "Cycles within cycles".

To conclude I just want to repeat that one problem with the theory is that a large enough sample is not possible yet, and that such projections could be the result of chance. It is something to keep in the back of an investor’s mind but not something to use alone to commit funds to the stock market.

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