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How to Play Defense When Market Risks Rise

The streak without an outlier day is over! Thursday’s S&P 500 close was enough to qualify as an outlier day. An outlier day is any trading day, up or down, that is beyond 1.50%. Prior to last week, the S&P 500 had gone since early May without a single outlier day. During a typical, bull market year, markets will experience between 10-20 outlier days. So far in 2023, there have been 14 outlier days, with 10 coming in the first three months of the year. None had occurred between May 5th and September 21st.

The streak of consecutive days without an outlier ended at 94 trading days. This is the 7th longest streak without an outlier since 2000, and the longest since 2018. We have been discussing the possibility of seeing an outlier day for quite some time now.

So, what happens next following an outlier? Historically, outlier days that follow am extended period of low volatility revert to normal market fluctuations. Prior to the move, volatility had been declining and bordered “extreme low” territory. That compression of volatility is like the squeezing down of a spring. Eventually, markets would have to let off some pent-up pressure. If outlier days continue to occur in succession, or we see several over the course of a few weeks, it would be a sign that the market is becoming much more inefficient.

Some Causes for Concern

While most outlier days that follow a period of low volatility resolve themselves and go back to normal fluctuations, there have been a few exceptions. The most extreme examples were the Covid trading anomaly that we saw in 2020, and the 4th quarter decline that occurred in 2018. Both of those market shocks came out of extended periods of low volatility.

We do not want to predict what the markets will do from here, but there are some causes for concern, and we have adapted the portfolios to accommodate (more on that in a second).

The market is experiencing a pullback that began in August. This pullback has been felt across most market sectors. One basic technical indicator that most non-technicians are familiar with is the 200-day moving average of price. This is a longer-term moving average and generally used to identify market trends. It is favorable for prices to be above the 200-day moving average, and unfavorable for them to be below it. While the S&P 500 is still above its 200-day moving average, most of its components are not. At the end of July, more than 70% of S&P 500 stocks were above their respective 200-day moving averages. Now, that percentage has declined to 42%. If we look at a shorter moving average, like a 50-day moving average, only 18% of S&P 500 stocks are above their respective 50-day moving averages. This is the lowest percentage since March.

Looking at the S&P 500 sectors as a whole (based on market capitalization weightings), there are only four sectors above their 200-day moving average. Two of those sectors, Consumer Discretionary and Information Technology, are starting to exhibit much higher volatility. Energy is the only sector above its 50-day moving average.

How to Play Defense in a Risky Market

Last year was a volatile year for most investors, aggressive or conservative. Both stocks and bonds saw significant declines. In 2023, the market has been held up by it seven largest stocks. Now, those stocks are starting to show signs of weakening.

Conventional wisdom would say that if the stock market declines, bonds should alleviate some portfolio volatility. Looking at bonds, however, there is a real problem posing significant risks to most investors. Rising interest rates cause bond prices to decline. So, unless you hold a bond until maturity, your investment will decline in value if rates continue to rise. Most bond investors do not own individual bonds outright—they own bond funds. Bond funds have no maturity. If rates continue to climb, bond fund prices will continue to decline. Since its peak in 2020, the long-term treasury bond ETF (ticker: TLT) is down -46%, and reached a new low last week. The intermediate treasury bond ETF (7-10 year treasuries, ticker: IEF) is down -24%. This does not sound very conservative.

Canterbury’s relative strength rankings have started to favor a few inverse equity securities. Inverse securities are positions that move counter to their underlying index. For example, an inverse real estate ETF would move in the opposite direction of a real estate ETF. Market risks are beginning to rise. To play some defense, and stabilize portfolio fluctuations, inverse securities can play a critical role in managing portfolio volatility.

There are quite a few very weak sectors right now. We discussed the weakness of small caps last week (you can view that post here). Additionally, the emerging markets have been weak (largely due to China), and the Real Estate sector has been the second-worst performing S&P 500 sector this year. Inverse securities for each of these market segments have been showing “buy” characteristics for a while now and are rising up our risk-adjusted rankings.

Bottom Line

Large cap indexes, like the S&P 500, just experienced their first outlier day in the last 94 trading days. The extended streak without an outlier has ended. More often than not, markets will return to normal fluctuations, but be on the lookout for more outlier days. An increase in the number of outliers will indicate market inefficiency and higher volatility.

The markets do have some clear weak points right now. After being held up by large technology-related stocks for nearly all of 2023, many sectors and larger securities are showing signs of weakness. Several market segments look like they are beginning to break down or are continuing to be weak. As a result, several inverse securities have risen up our rankings list.

Bonds have been one of the more bearish asset classes in 2023. They were also bearish in 2022. Rising rates have a negative impact on bonds, particularly if investors own bond funds, which have no maturity date. In other words, if the markets were to decline, there hasn’t been much reason to believe that bonds will lower a portfolio’s volatility.

The Portfolio Thermostat has already made some adjustments to accommodate current market conditions, including owning some stronger ranked sectors like Communications and Energy, as well as some inverse securities to stabilize portfolio volatility. As markets rotate, the portfolio will continue to adapt.


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