How to Navigate Emotional Markets

How to Navigate Emotional Markets

Posted on April 06, 2020
When turning on the financial news and seeing discussion of the markets, the news pundits are most often referring to the S&P 500 or the Dow.  The S&P 500 and Dow Jones Industrial Index are only part of the overall broad market picture. They represent large cap stocks.  In fact, the S&P 500 is 25% weighted towards large-cap technology stocks.  We have mentioned that technology has shown risk-adjusted leadership throughout this event, and so far this year, the S&P 500 is down -23% and the Dow is off by -26%.  While these two indexes represent the largest US stocks, they do not represent all US stocks.  In fact, during this epidemic, many US indexes have struggled greatly when compared to the S&P 500.

The table below shows the style indexes so far this year, both at their current levels and at their lowest point.
 
US Style Current Drawdown Largest Drawdown 2020
Large Cap Growth -18% -25%
Large Cap Value -29% -37%
Mid Cap Growth -30% -37%
Mid Cap Value -41% -46%
Small Cap Growth -35% -38%
Small Cap Value -44% -46%
 
From the table above, you can see that Large Cap Growth (technology) is substantially outperforming.  Also, while large caps may only be down -23% to start this year, mid-caps and small caps are showing much more weakness.

Global Markets
When looking at Canterbury’s proprietary risk adjusted rankings, which take into account a security’s relative strength in combination with volatility, China is the number one ranked security on a risk-adjusted basis. Why would China, the source of the virus, be ranked #1 on a risk-adjusted basis? Well, that doesn’t matter.  All that matters is that, that is reality. 

Supply and demand are counterintuitive.  In environments like we are in today, markets can go up and down when investors would least expect them to do so.  The Coronavirus news did not improve over the weekend.  In the US, there are now a reported 350,000 cases of Coronavirus, and sadly 10,000 deaths.  It also seems like things have the ability to get a lot worse before they get better.  That being said, when looking at the markets at the time of this writing, the S&P 500 is up more than 5% today.

Markets, in emotional environments, have a tendency to overreact and discount a lot of information.  The markets will get better before the news is at its worst, just like the markets took a freefall prior to the news being this grim.
These wide-ranging, huge up and down days can be exaggerated, and cause an equal and opposite reaction in the other direction.  In other words, the market has not found its footing just yet.  Until it does, expect to continue to see these wide-ranging days.

How do we manage this type of environment?
The wide range of emotion that the market has been trading with is certainly not normal.  We have seen multiple days beyond +/-4%, and even quite a few days pushing +/-10%.  It seems these wide-ranging days have become a new normal for the market, at least in the short term.  The question becomes how do we manage this type of environment?  

Managing an emotional market environment requires a disciplined approach.  The Market was sitting at a new high on February 19th.  Twenty trading days later, and it was down -30%.  Heading into this trading event, the Thermostat was positioned for a bull market, with a higher exposure to equities.  During the stretched downswing, we had stressed that highly emotional markets work both ways.  Just as you can experience an anomaly to the downside, there will be large swings to the upside as well.  It is important to have the same, or more, exposure on the kickbacks as was had during the initial drawdown.

Since posting the videos which mentioned inevitable kickbacks, the market has had some upside, coming off of its low point.  From here, the Thermostat can begin to navigate this environment by benefiting from the market’s volatility and large swings (by adjusting exposure to the markets with each swing). 

Some of the steps that the Thermostat has made during the recent kickback include adding a position in the inverse Russell 2000 (small cap stocks have been very weak throughout this environment) and also adding a position in inverse EAFE (many international developed countries have shown relative weakness to the US markets).  These positions help stabilize part of the portfolio, should the market attempt to retest its prior low.

In addition, the Thermostat continually looks at its current holdings and make adjustments by allocating to positions showing higher risk-adjusted strength.  Because of this, the Thermostat recently took a position in China, which was mentioned in this update as being one of the stronger equity markets on a risk-adjusted basis.  The idea here is to have long positions in the higher ranked equities and inverse positions in weaker equity classes.

Bottom Line
It feels like, in both daily life and in the markets, we are living in the movie Groundhog’s Day (starring Bill Murray).  While each day brings different events, the market is experiencing the same level of volatility over and over again, swinging both up and down.  Hopefully, this type of behavior resorts back to low volatility sooner rather than later, and the market can rebound back to a new high, but in the meantime, the Portfolio Thermostat can manage some of these large swings by increasing and decreasing market exposure at various points.  Again, this all goes back to the idea of having more exposure during kickbacks than was had during the pullbacks.
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.

 
Canterbury Investment Management: Tom Hardin

More About Brandon Bischof

Brandon is directly responsible for managing the Canterbury Analytics Group (CAG). To date, Canterbury Analytics Group has played an important role in advancing portfolio management from a loose art form based on subjectivity and obsolete assumptions to an adaptive process with scientific rules and methods capable of providing evidence based results and statistically relevant value add results.


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.