The market rallied very strongly in Q1 2019. S&P 500 is up about 13% for the quarter and this is one of the best quarters since 1998. Although it seems like the resumption of the bull-market, we believe that the fundamentals and valuations do not support it and the risk is too high to be fully exposed to equities. We are net-long as the companies that we have in our portfolio have strong fundamentals and reasonable valuations but we are short index as we believe that the index as a whole is overvalued. Weakening fundamentals and overvaluation are recipe for a disaster and we are getting prepared for the disaster that is likely coming soon.
Our macro model has been highly predictive of future revenues/earnings and future stock prices. Some of those variables that are used in the model are Eurodollar futures, 10-year note, emerging market equities and debt, corporate bonds, US financial index ETF, South Korean export figures, lumber futures and VIX among few more.
In the last 20 years the model has given 11 signals where 7 were true, 3 were false and 1 is still open. The average gain on true signal is 31% and the average loss on a false signal is 7%. The model turned negative in early 2018 and has not given us a buy signal yet. The important thing to remember here is that the model provides us a macro view but does not tell us the exact time the market will go up or down.
When the model first gave us the “sell” signal in January 2018 SPY was at $275, then the following month it went as low as $247, then it rallied and went to $290 in September 2018, then it fell to $232 in December 2018 and has now rallied to $283. When we look at the first time, we got a “sell” signal we have seen significant declines and rallies but when we look at the overall picture, we are within few percentages from the first sell signal.
What makes us think the time is right for another sell-off now?
We admit that we are not good enough to pick the top or the bottom but we also believe that one can identify times when it is prudent to take more or less risk. There are few indicators that have worked fairly well in the past that tell us when it is better to be fully invested or partially invested.
- Inter-market analysis: We are big believers in inter-market analysis and believe that there are certain relationships that hold true. When these relationships start diverging from the historical relationship, we start to look for ways to protect our gains. The relationships that we are looking for is the price-action between small caps (IWM) and semiconductors (SMH) to S&P 500 (SPY).
In the charts below you will see that IWM and SMH are unable to make new highs as SPY is making a new high. I have circled those areas and I have circled what happened in the past when similar thing happened. These divergences do not always work but when the macro model is down these works more than 90% of the time.
VIX Short positions: The next thing we are looking at is the net positioning in VIX. Currently the short VIX position is higher than what we saw during February and October-December selloffs. This by itself is not a great signal but when combined with the macro model, it has provided timely signals.
Increase in Implied Volatility: Last month we saw an increase in implied volatility. This is a short-term signal where traders are betting on future volatility being higher and are buying insurance. In the past these types of moves have happened before a large market decline.
Making Forecast Vs. Managing Portfolios
Identifying the long-term direction of the market and managing portfolios are two separate things. Even when we are able to identify the long-term direction correctly it is hard to time the market so that we have the largest gains. Often times the model is incorrect and we will be missing out on potential gains too if we exit out too soon. Therefore, I have found that it is important to progressively build positions as our thesis materializes.
Currently, we have 20% in hedges, 10% in cash and 70% in common stocks. Our portfolio beta is 0.5 so if the market were to rally here, we will make half of S&P 500 but if the market were to decline here, we will lose half of S&P 500. As our thesis materializes and conviction solidifies, we will be adding more hedges or selling some stocks so that we can bring the portfolio beta to 0.25. Our goal is not necessarily to make money if the market goes down but we want to protect the gains that we have made so far and not lose as much.
We are up 10% YTD vs. 13% for S&P 500. We feel good about our portfolio holdings based on our analysis of the market and the fundamental conditions.