Time to Read: 3 Minutes
To begin, at BWM our hearts go out to all the people worldwide affected by the events unfolding in Ukraine. It feels odd to write an article about the stock market and our objective indicators while reading about innocent lives lost due to Russia’s invasion of Ukraine. With that said, we have a commitment to keeping our clients informed about our thoughts and position changes in our portfolios.
Last week, we reduced our overweight equity exposure to neutral by cutting US equities by 5% across all models. Proceeds from this transaction were added to our position in short-term Treasury securities. We took advantage of last week’s rally to make the adjustment based on our three core rules of tactical investing: (1) Don’t fight the Fed, (2) Don’t fight the trend, and (3) Beware the crowd at extremes.
As we discuss below, our three-rule framework is not currently returning bearish results across the board, which is why we only reduced equity exposure to neutral. It is also important to clarify that the reduction in equity exposure was not done in response to the geopolitical events between Russia and Ukraine. The events influenced signals and indicators that we monitor, but we are not making a prediction about the outcome of the invasion.
Crisis events historically followed by a rally
Unfortunately, crisis events happen in the world more often than we would like, presenting us with an opportunity to study historical patterns. As shown below, the initial decline leading up to or during a crisis has typically been followed by a rally if the market perceives the event to have little impact on the global economy.
While the table below shows positive mean and median returns for the periods between one month and one year following a crisis event, it also illustrates several instances where the Dow Jones Industrial Average (DJIA) posted negative returns across the time periods considered as the market moved from oversold to overwhelmed. Upon further review, we note these instances of negative returns often happened when the Federal Reserve (Fed) pricked a bubble and a recession was in the works.
Rule 1: Don’t fight the Fed
Aligning our portfolios with this rule will likely be our biggest focus for 2022. While the Fed has been talking tough on inflation, the jury is still out on how hawkish it will actually be, given clear evidence the global economy is slowing from the breakneck pace set during the recovery following the pandemic-induced recession of 2020. In fact, the Global Recession Probability Model from Ned Davis Research (NDR) just moved into the high-risk zone, as shown below.
To be clear, this chart doesn’t necessarily mean a full-scale global recession is imminent. Rather, it helps identify a slowdown relative to the growth the global economy had been experiencing. Given the rapid pace of growth following the 2020 recession, the model is indicating growth rates going forward will likely be much lower.
On the other side of the Fed debate are arguments about extremely high year-over-year inflation and incredible job growth prompting the Fed to reduce its bond purchases and likely increase interest rates to achieve a more “normal” policy environment. If the Fed needs to increase rates more quickly than currently anticipated or aggressively unload its massive balance sheet, then we will have to turn more cautious out of respect for this rule. For now, we believe the Fed’s current trajectory still seems to support the financial markets.
Rule 2: Don’t fight the trend
In a perfect world, we want to be overweight equites when the market is in a clear uptrend, allowing our profits to run, and become defensive before a prolonged downtrend to minimize losses. This reasoning explains why trend and momentum indicators are so important to us at BWM. The recent market decline shifted our stance regarding the “trend” from neutral to bearish.
We have featured the NDR chart below on many occasions. This indicator helps us analyze the trend of the US stock market. The bottom portion of the chart is the Big Mo Multi-Cap Tape Composite, which looks at the “health” of the stock market as represented by the S&P 500 Index. The Composite recently dropped into the bearish zone, creating a “sell signal” for the S&P 500. While not all of our momentum indicators have broken down, the weight of the evidence on momentum leans bearish at the moment.
Rule 3: Beware the crowd at extremes
Our third rule of tactical investing is a contrarian rule urging caution when the crowd is too optimistic or too pessimistic, as such extreme feelings are usually an indication for us to do the opposite. One tool we use to assess the crowd is NDR’s Daily Trading Sentiment Composite, shown in the lower portion of the chart below.
The current reading of 16.67 is well below the Extreme Pessimism line in the sand at 41.5. We believe this very low reading might help explain why the US stock market rallied late last week despite the negative news. By the time Russia invaded Ukraine, the market had already experienced a lot of downside pressure, removing many sellers and allowing for a bit of a relief rally. While it is likely this reading will be higher by the time of publication, the extremely pessimistic reading is a positive for markets.
The bottom line
We believe risks have risen to a point where it no longer makes sense to be overweight equities. However, two of our three rules remain bullish; therefore, we do not believe it makes sense to get overly defensive at this time. The market hates uncertainty and the high levels of current inflation and geopolitical events have injected a large amount of uncertainty into the global economic system. We will continue to watch our objective indicators to help us determine if this is just a correction that leads to another advance or the beginning of something more troubling, in which case we would continue to reduce our equity exposure.