A Picture is Worth a Thousand Words // April 25, 2016

A Picture is Worth a Thousand Words // April 25, 2016

Posted on April 26, 2016
Weekly Update

Market State 7: Transitional - As discussed in the past, the Portfolio Thermostat is composed of 12 primary Market States. Each is reflective of certain characteristics that either indicate a Bullish, Transitional or Bearish overall market environment.
The Bullish Market States (Market States 1 through 5) all have similar price behavior characteristics. Bullish Market States can be indication of an “efficient market” that has established a long-term upward trend, with higher highs and higher lows, in price. In addition, bull markets tend to have low and/or decreasing volatility, as well as a variety of positive supply and demand indicators. 

The current environment is labeled Transitional because it does not meet the primary characteristics of an established bullish trend of higher highs and higher lows.

Canterbury Volatility Index (CVI = 74) - A reading of CVI 75 or lower is considered to indicate a low-risk environment. The market risk is typically limited to 8% to 12% from the peak (which in this case would be the 2130 high in May of last year), provided that the volatility remains below CVI 75.
Short-Term Overbought/Oversold Indicator: The market is in a 69% oversold reading (Neutral). A reading of 95 or higher, either overbought or oversold, is considered to be an “extreme” level.

A Key Understanding:
The Canterbury Portfolio Thermostat is based on the following premises:
  • Bullish Market States are more about the predictability of short-term declines than advances. Our studies show that the maximum decline, from the peak value, is typically 8% to 12% in a bullish market environment. This coincides with the traditional definition of a normal bull market correction of 10% which is considered to be normal market-specific (random) noise.
  • This is made when the portfolio hits a new high in value. The smaller declines, from the peak, should take a shorter period of time to register a new high and thus make money. This is why it is so important to manage the size and scope of any declines.
  • The Portfolio Thermostat’s job and methodology is to identify ETFs that have similar characteristics to those that are observed to be performing strongly in bull Market States.
  • The Portfolio Thermostat’s algorithms are designed to adjust ETF holdings in order to move in concert with the ever-changing market environments. The objective is to maintain a bullish “Portfolio State and thus experience only the normal market noise which is part of the price to be paid for liquidity.”
The key to long-term success in managing financial securities is risk management. The upside returns will take care of themselves as a result of creating and maintaining an efficient portfolio. In contrast, portfolios with holdings that have the characteristics of bearish market environments are marked by sharp declines and advances, such as the approximately 15% advance experienced over the last 50 or so trading days.
The S&P 500 index is no longer showing the characteristics of a long-term bullish trend. Sharp countertrend rallies are the norm for bearish environments, though. The following charts will help give a visual appreciation for the breadth of the difficulty experienced in the markets over the last eight to twelve months:
The Russell 2000 (small cap.) index has clearly broken its four year bullish trend and is currently experiencing a normal and expected dead cat bounce.

The MSCI EAFE (large cap.) International Index is showing consecutive lower lows and lower highs.

Emerging Markets have had a rough go since 2011. The rallies, like the current one tend to follow sharp declines.

The MSCI World Stock index covers a lot of stocks. Long away from the high.

The Russell 3000 covers almost 98% of the U. S. market capitalization. The question is: does this show a huge “bull trap” or the beginning of a healthy and rational new bull market?

This next chart is an illustration showing why risk management is the critical component in producing compounded returns. These recent rallies in the indexes below might have reached the double-digit percentages but still could not get back to test the old highs.

Bottom Line:
The nature of the last advance may have the characteristics of a very large “bull trap.” Investors are seduced into believing that they are missing out on an opportunity but only the future can determine whether this was a true opportunity or a false reaction. Time will tell whether the market will transition to a bull or whether that advance will be wiped out in a resumption of the bear market. If it’s the first case, it will seem obvious in hindsight but if the latter is true, the frustration of missing out will soon be forgotten.
We know from the history of markets that a strategy built on just buying/holding and rebalancing will not provide an adequate risk-adjusted return over time. We are well aware that even a moderately conservative portfolio continues to be subjected to 25% to 50% declines during inevitable bear market environments. In fact, it would be naive to believe that the double-edged sword of law of supply and demand liquidity will just simply work itself out and that investors will be rewarded for just simply doing nothing. 


Canterbury Investment Management: Tom Hardin

More About Tom Hardin

As Chief Investment Officer, Tom has more than 30 years of experience in the investment management industry and has a broad breadth of knowledge. He is known as an innovator, educator and has been revolutionary in the advancements of portfolio and risk management.

Every effort was used to provide accurate data and mathematical calculations to provide, what we believe to be, accurate results. Canterbury Investment Management, LLC, and its principal owners, make no guarantee of completeness or accuracy of data or calculations as well as conclusions of any statistical data or information contained in the simulation illustrated on this page. Past results or performance is in no way a guarantee of future results.