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Sunday, 11 February 2018

Time sell stocks and raise cash?

After the recent substantial increase in volatility in US stock indices, it makes sense to ask the question, whether it'd be wiser to lower the exposure and either raise cash or diversify into assets and strategies that have potential to make money in the coming months and overall in 2018. 

In this brief article, I will provide several reasons for seriously considering reallocation investments from long-only equity strategies to other types of investments. But: I do not provide investment advice. Those that are applying active trading strategies instead of investing will benefit as they are challenged (by the facts presented in this article) to consider reasons to short the stock markets as well as shortening their time horizons for long trades. Explosion in volatility has very likely caused a shift in the market psychology. Bulls are now much weaker in their convictions and could be persuaded to either sell (part of) their holdings as markets rally and consider buying puts, invert ETFs or selling short futures to hedge their existing holdings. At the same time, hedge funds could be looking for opportunities to go net short at levels where they believe markets are getting short-term overbought. All these actions result in a weaker market and could turn this correction into a larger down move. This could mean that markets have topped and entered into a new bear market phase. How likely is this and what reasons we have to assume this would be a reasonable and even probable outcome in the following weeks and months? I will cover some fundamentally important points over the following paragraphs.

Stock market volatility exploded in the US
Volatility growing after a long period of rising prices is a well-known sign of trend growing old and weak. This is when the probabilities for a market turning lower are high. We saw this phenomenon taking place when the markets topped after the tech bubble in the year 2000 and after the bull market between 2003 and 2007. The VIX rally that started on February 2nd went hand in hand with 200-day ATR (Average True Range) exploding from 130 DJIA points to over 1200 points. These are clear signs that something has changed in the market psychology and therefore traders are likely to employ different strategies. They are also likely to react to news and market events differently - in a more defensive manner.

SPX rallied for 15 months without a single down month
The recent explosion in volatility was baked in during the previous 15 months of over-eager buying into stocks. There were no down months during this time. The rally started after the election of Donald Trump and has continued on anticipation that his tax cuts bringing growth and prosperity to US companies. These expectations turned into a 35% per cent rally in S&P 500 before the market turned lower on January 29th. If we accept the stock market long-term annual average return to be 8%, this rally represents over four years’ typical gains. It is, therefore, reasonable to assume that the benefits anticipated from Trump’s tax were quickly priced in and perhaps even overpriced to the stocks.

Schiller PE is in bubble territory
According to the famous Schiller PE for S&P 500, the stock market evaluations are now near to record territory. In fact, this valuation metric is now higher than it was right before the stock market crashed in 1929 while the only time it has been higher was during the technology stock bubble in 2000. Therefore, it is fair to say that S&P 500 valuations are now in bubble territory. What's important to remember is that it is a historical fact that good stock market returns have followed low valuations and poor or negative stock market performance has followed extremely high valuations. There is no question that we are now dealing with markets where upside potential is getting limited. Those buying into stocks now are buying at very high valuations. 

Margin debt is at record highs
Margin is a great tool when markets are moving in your direction, on this occasion higher. However, when the market turns these leveraged bets have to be unwound quickly or they cause margin calls and turn into forced liquidations. Any support gained from borrowed funds evaporates quickly when volatility increases. Business Insider reported at the end of December 2017 how the US stock markets where more leveraged than ever in the history. This means that larger than ever proportion of long positions were in fact highly geared and initiated with borrowed funds that could evaporate from the markets at any time. 

Rising interest rates are slowing down stock buybacks
Over the last few years, the extremely low interest rates have allowed the companies to take out cheap loans to finance share buyback operations. These schemes have helped the managers to achieve their targets that are often either share price or EPS (Earnings Per Share) oriented. While the buyback programs obviously support the share price thus helping the managers to reach their performance targets the buyback programs have also helped to reduce the float, i.e. the number of shares traded in the stock exchanges. This, in turn, has made the per share earnings numbers look better even though no actual improvement in earnings has taken place. Additionally, as companies buy back their own shares the EPS number, (an important valuation metric), gets better for the stock market as a whole. This is obviously misleading and distorts the valuations. Now, that the bond markets are signalling inflation and the Fed is expected to hike rates several times this year alone, financing of share buyback operations gets more expensive. This is likely to decrease the number of these operations, thus decreasing demand for stocks. 

Black Swan events could scare the markets 
With margin debt at record high levels, interest rates rising and stock market valuations in the bubble territory stock markets are more vulnerable in the event of a black swan appearing and surprising the markets. On top of this the usual suspects of Chinese shadow banking debt, Middle East Crisis, Impeachment in the US or North Korea could become an unstabilising factor that turns the market lower or accelerates a decline that otherwise would have been a measured stock market correction.

Over the next few months we expect that the SPX will be ranging between 2500 and 2900 points creating opportunities for swing traders. In the light of the above we find it reasonable to look for returns in strategies other than long only equity. We like cash, private equity, active trading and market neutral strategies. However, we DO NOT provide investment advice. Therefore, we strongly recommend to discuss your investments and strategies with a licensed investment advisor before acting upon any of the views published in this blog.


Janne Muta
Chief Analyst
TradeCompiler Research Ltd.

Disclaimer: the views expressed are our opinions of the markets and are NOT to be interpreted as investment advice. All the content on this site is made available purely for educational purposes. Trading with leveraged products is risky and traders might lose more than their initial deposit. Past results are not a guarantee or indicator of future results.