Money & Finance - Behavioral Models Indicate a Market Correction

As we mentioned in last week’s note, the model was revealing significant cracks in this current rally and we were anticipating a coming correction for the U.S. equity markets.  Well, it’s Official. We have received a definitive “sell” signal from our behavioral model.

Late in the day yesterday the model turned over. We have rebalanced our portfolio as follows. In our aggressive equity program we took a short position, in our enhanced yield program we took aggressive defensive positions and in our separately managed accounts we went to cash.

This week we thought it relevant to go through the past five years and demonstrate how the mathematics of our behavioral model has kept us out of harm’s way through tumultuous times.

In figure 1, we showcase the weekly closing prices for the S&P 500 during 2012. As one can gleam from the chart, the model provided an appropriate exit the week of April 16th. The S&P 500 went on to correct some 8% from that point on. 

In figure 2, we received two sell signals for 2011. The first came in the week of March 7, 2011. This was a short lived correction lasting only three weeks where the S&P 500 went on to correct only 4% or so. Later in the year though, we collected information that registered a sell in the week of June 6, 2011. This signal lasted almost three months in which the S&P 500 corrected 13% from our sell signal.

Figure 3 shows the S&P 500 weekly closing prices in 2010. There were two sell signals that year, the first coming the week of January 25, 2010. This correction lasted six weeks through the beginning of March.  This proved to be a mild drop of around 3.5%, but better to err on the side of caution. Later that year the model produced another sell signal the week of May 10, 2010. This correction lasted eleven weeks and the S&P 500 dipped 12% from those levels.

The markets had an exceptional run in 2009, coming off a miserable 2008. The model kept us safe through the double bottom correction in early 2009. Figure 4 indicates the sell signal coming the week of January 20, 2009 and lasting nine weeks. During that time frame the S&P 500 fell as much as 16%. Later in the year we noticed two other warnings, both of which proved to be benign. The two weeks in July and November can be written off as false positives. Once again it is better to be cautious than sorry.

The U.S. Equity markets in 2008 were certainly the most challenging in a generation. It puts to test the integrity of the model and how it fares when extreme outliers are involved. Interestingly enough, the behavioral model kept us OUT of the market a full 39 weeks during the course of the year or 75% of the time. Figure 5 graphically shows the weekly closing prices for the S&P 500. It indicates holding cash starting the first week of the year through the end of March. During which time the S&P 500 lost 9%. Then again the week of June 9, 2008 we received the signal to get out of the stock market.  The market lost another 11% during this period. Then of course towards the end of the year, another signal was produced the week of September 15, 2008 through the end of the year. This saved us a total of 37% that would have otherwise been lost if one would have held their position through the downturn.

In the end, the mathematics does not lie. While interpretation is an art as much as a science, one needs to learn to trust one’s instruments when navigating the market. Certainly our behavioral technique is no panacea, and we are students of the market, subject to its lessons taught. That said, it gives us comfort in knowing that, through profits and losses, we have an established methodology that puts as much weight on risk management as it does on return expectations.

Probability investing of this type certainly needs some taking used to.  With the sell signal received yesterday, I sent a text to my friend Joseph that has been watching closely the market indicators. I send this letter to our investors in the hopes of easing concerns about portfolio risk. Rest assured JSK places the utmost importance on safety of capital.

Bottom Line: We are positioned defensively for what we perceive as a coming market correction. We will remain defensive until such a time that our models indicate it is safe to wade back into the market.

-Joseph S. Kalinowski, CFA

Twitter: @jskalinowski

 

 

 

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