The market rose into resistance and pulled back a bit, even as the short-term trend picture improved significantly. The reported earnings were strong, but manged to disappoint some traders. On a different note, I explore the performance of bonds, gold and commodities in providing diversification during this year's decline (hint: the results may surprise you).
Chart 1: The broad-based NYSE Composite rose into resistance and pulled back a bit. There are many layers of resistance overhead, as I have been saying in my past several posts.
Short-term Trends Turn Bullish
In my view, the most important development this week was the broad-based improvement in the short-term (25-day) trend picture. Whether measured across market capitalization (see Chart 2) or key indexes (see Chart 3), the short-term trend has turned bullish across the board. These trends were deeply bearish only two weeks ago. So the last two days notwithstanding, the bulls have loosened the grip of the bears. As Chart 2 shows, small-cap stocks are the strongest area, and large-cap and mega-cap stocks are still taking a beating on the intermediate-term time frame.
Chart 2: The Short-term trend are all green (bullish) across all market capitalizations and portfolio styles as measured by the Vanguard market-cap weighted ETFs. This marks a significant improvement over the past two weeks.
Chart 3: The trend-check carpet is all green in the top row (short-term) time frame. The medium-term picture has improved (to neutral) across the board. The intermediate-term picture is mixed, partly due to the lags in the data due to smoothing. The long-term trends are mostly bullish, and have mostly remained so. The number of stocks in the indexes increases from left to right, from 30 to over 2500. The time interval doubles at each step from top to bottom starting with 25-days.
Did you Suffer from PDM (Portfolio Diversification Malfunction)?
Diversification is the antidote to market volatility, or so the theory goes. What could be easier: just combine things with negative correlation. Entire forests have been cut down in praise of portfolio diversification, and a few common tools are bonds, gold and commodities. So I examined how well they offset the market declines since the January top. The results are quite revealing. Even though bonds, gold and commodities have a historical tendency to offset stock market declines, they failed to do so this year (see Chart 5).
Chart 4: I compared the daily performance of the $SPX (red line) to components that could diversify the portfolio: SGOL ETF which holds gold bullion (blue line), the Proshares DB Commodities ETF (green line) and the broadly diversified BND - Vanguard Total Bond Market ETF (pink line). Each of these investments actually declined with the stock market during the February sell-off.
Rolling 10-day Correlations Were Positive
For diversification to work, we want the "diversifiers" to have a negative correlation to the stock market during the period in which we want portfolio protection. However, the opposite seems to have happened, since we observe a positive correlation to stocks on a rolling 10-day basis during this year's market drop.
Chart 5: The rolling 10-day correlation of the Vanguard BND ETF was positive during the February sell-off.
Chart 6: The SGOL ETF, which holds gold bullion, had a positive 10-day rolling correlation to the $SPX during the initial sell-off. The re-test of the lows however showed a negative correlation for at least a few days, but it may have come a bit late in the process.
Chart 7: The correlation of the broader DBC commodity ETF mirrors the correlation of gold to the $SPX.
Short-term Bonds and Short-SPX ETFs Show Negative Correlation
As we should expect, cash or near-cash (very short term treasuries) should show a negative correlation to the market during major declines. I used the iShares Short-term Treasury ETF (SHV) to illustrate this pattern. As you can see in Chart 8, the SHV had a negative correlation to the $SPX (measured on a 10-day basis) during both, the initial decline and the re-test. For completeness, I show the return and correlation of the Direxion S&P 500 Daily Bear 3X ETF (see Chart 9 and 10) to illustrate the positive returns and perfect negative correlation to the market during the decline. Naturally, the high leverage and other aspects means this ETF is too speculative for the vast majority of investors, but it correctly illustrates the offsetting nature of a short-position during market declines.
Chart 8: The iShares Short-term Treasury ETF (SHV) is a "near cash" investment vehicle, and it showed a negative correlation to the $SPX during the declines, as we should expect. Thus cash (or near cash) provided a positive offset, however small, during the declines.
Chart 9: The Direxion Daily S&P 500 Bear 3X ETF, which holds a short position in the $SPX, had a perfect -1 correlation to the market through out the decline, per its design. It also provided positive returns (see below), but may be too volatile for most. It is shown here to illustrate the effects of having short exposure during declines.
Chart 10: The Direxion Daily S&P 500 Bear 3X ETF had positive returns during the decline, as it must from its short exposure. Naturally, this is only here for illustrative purposes, and this ETF is probably too volatile for most investors.
The Portfolio Construction Conundrum
Bonds, gold and commodities were imperfect hedges during this year's decline. Cash or very short-term treasuries are probably the best alternative for the typical investor during declines. Since holding cash during strong trends can lower portfolio returns, perhaps some form of technical trend-following could be more helpful to manage your allocation to cash.
I expected a pullback this week from my last post. More earnings will roll-in next week, but bulls remain jittery, and the overhead resistance (shown in Chart 1) must be overcome before sunny skies will be visible to the bulls. In the new normal, geopolitical and head-line risks are still fraying trader's nerves.
A review of the joint relative and absolute sector performance offers insight into areas you may wish to explore as you look for investment ideas (see Chart 11).
Chart 11: The ETFs in the upper right hand quadrant offer interesting sector opportunities as the market tries to rebound off the double bottom. Counter-trend traders (value investors) may consider the sector ETFs in the left half or lower left-hand quadrant.
I hope you have enjoyed our little detour into the dense thickets of portfolio construction and will sign up for the blog using the fast link below.