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Complacency in the Stock Market

Posted on 04 March 2010 by Allgen Financial

Summary
- Emotions are the greatest force that drives the markets
- Extreme fear has historically accompanied major market bottoms
- Extreme greed combined with complacency have historically been present at market tops
- A prudent money manager will look for extreme fear to buy and high levels of complacency to sell or go defensive.
- After starting 2009 in extreme fear we entered into 2010 with a very high level of complacency
- Because the market became overly complacent early this year, we made moves to go defensive
- We believe the potential downside risk is greater than the potential upside gain.
- Going forward we will remain defensive until the market presents better opportunities

com·pla·cent
–adjective
1. pleased, esp. with oneself or one’s merits, advantages, situation, etc., often without awareness of some potential danger or defect;
(dictionary.com)

For the waywardness of the simple will kill them, and the complacency of fools will destroy them;
- Proverbs 1:32

When a great team loses through complacency, it will constantly search for new and more intricate explanations to explain away defeat. - Pat Riley

How Fear and Greed Drive the Market
Many analysts, academics and economists will tell you that markets make moves in certain directions because of “Fundamentals” (earnings growth, economic trends, etc.) and/or “Technicals” (momentum, money flow, breakouts, etc.). To some degree they are correct, but in my opinion the greatest force that moves the markets are the emotions of fear and greed. Both fear and greed are huge motivational factors in the market. In general, fear will cause people to sell and greed will cause them to buy. Extreme fear is usually accompanied by panic and historically that is when market bottoms are formed. This phenomenon occurs because massive amounts of people will capitulate (surrender) and sell regardless of the price, at which point the supply of sellers will virtually dry up leaving very few people left to sell. Wise institutional investors will take advantage of this rare moment and buy shares at extremely low levels. Then, the rest of the market will follow once they see prices rising providing a significant level of demand that will give the market a sustainable amount of buy orders (demand) in order to push the market up for a long period of time. An example of extreme fear would have been in late 2008 and early 2009. It was no coincidence that a significant bottom was formed during that time and a great buying opportunity occurred. On the other hand, extreme greed is usually accompanied by complacency or a lack of fear that the market will fall. Extreme greed and complacency historically mark market tops. Extreme complacency will cause the market to be vulnerable because virtually everyone believes the market will go higher so everybody would already be invested leaving very little potential demand of new buyers. Conversely this leaves an abundance of potential sellers (supply). An example of extreme greed was in late 1999 or early 2000 when the majority felt that they had to buy into stocks and there was little fear of the market falling. A prudent money manager will look for extreme fear to buy and high levels of complacency to sell or go defensive.

After starting 2009 in extreme fear we entered into 2010 with a very high level of complacency. Even after going through the worst bear market since the “Great Depression” you would think that the majority of people would still be recovering from the massive scars that markets left them with in 2008. Although, admittedly not everyone feels like the economy is on sound footing, according to most indicators that measure sentiment the market became very complacent in early January and still has a high level of complacency considering everything that we just went through over the last couple of years. The main way that we measure complacency and fear is by looking at the CBOE Volatility Index (VIX). Historically, when the indicator is high (above 40) it is considered extreme fear and when the indicator is low (below 20) it’s considered a high level of complacency. In (Figure 1) below you will see that when the VIX hits high levels above 40 the market has bottomed and when the VIX goes below 20 the market has topped.


(figure 1) (Click on the graph for larger image)

Our Recent Market Moves
Because the market became overly complacent early this year, we made moves to go defensive and take profits on many of our positions that we bought in late 2008 and early 2009. In our actively traded accounts we now hold about 40-50% of the entire portfolio in cash. Plus we’ve bought into long-term government bonds as a hedge against a falling market. Long-term government bonds are considered a safe haven play. I know that may be hard to believe because of our large government deficits and high amounts of government debt, but it is true still to this day. In fact, in 2008 when the market was down nearly 40%, long-term treasuries were up over 30% for the year. In our strategically allocated accounts I have increased some cash, but mainly we have transitioned a portion of the riskier assets like commodities, emerging markets, international equities and small caps over to more domestic value stocks and other traditionally more stable areas. Similarly we have transitioned our bond portfolios from riskier funds into traditionally safer areas. The moves were made because of the potential market pullback. Certain factors historically point towards a more aggressive investment position, a good example would be early 2009 when stocks were at decade lows and there were extreme levels of fear and other circumstances point towards a defensive posture, like the beginning of this year when some stocks indices had rallied over 70% or more in a matter of 9 months. After the market has moved that much to the upside in that short of time combined with a high level of complacency there is cause for concern which is why we went defensive.

Strategy Going Forward
We plan on remaining in a defensive posture in the attempt to preserve wealth and to be ready for when the market pulls back. We will attempt to wait for high levels of fear in order to purchase equities at lower prices than what they are going for now. If the market pulls back as anticipated, we will be ready to put some of the cash back to work. But for now we believe the potential downside risk is greater than the potential upside gain. So we will remain defensive until that environment changes. A wise money manager will always try to target a greater amount of potential gain than what they are willing to risk and currently those opportunities are not readily available. Once they become available we will try and take advantage of them again.

Allgen’s Investment Approach
Allgen specializes in active money management. Through technical and fundamental analysis, along with a contrarian mindset, we strive to navigate the markets during periods of prosperity and/or decline. We constantly research and study the markets to find the next emerging area even in asset classes that are typically not used in your “buy and hold” asset allocation portfolios. During the good times we focus on strength, and during the bad times we try to preserve wealth. During periods of stagnation, such as we are experiencing now and potentially years to come, we see ample opportunities to take advantage of this market. If you want to see how active money management may fit into your overall investment portfolio then please email us advisors@allgenfinancial.com or give us a call at 1-888-6ALLGEN (625-5436).

Written By:
Jason Martin, CFP®, CMT
Senior Partner & Chief Investment Officer
Allgen Financial Services, Inc.
martin@allgenfinancial.com
888.6ALLGEN

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Buckle Your Seatbelts

Posted on 13 September 2009 by Jmartin

The market has shown signs of recovery this year achieving a 13% return through August 31st 2009. This has led the way to an improving economic outlook, with an expected positive GDP in the third quarter. The market has rallied over 50% since its lowest point in March, but is showing signs of a potential pullback over the short-term. This could lead to a pullback of 7-10% from current levels over the next few weeks. We are looking for a pullback in the S&P 500 to a level of 920-950. This pullback will most likely be intense and cause a lot of fear. These types of intense pullbacks will cause the “weaker hands” to exit the market which should lead the way to a solid intermediate term rally into the end of the year. As you will see in figure 1 and 2, there are two distinct technical patterns which have targets of 1,230 for the S&P 500 (Figure 1) and 11,100 for the Dow Jones Industrial Average (DJIA) (Figure 2). Although this may seem like an enormous run from the lows of March to the projected highs, the greatest rallies of all time have followed the largest pullbacks of all time. The 2008-2009 financial crisis was the largest negative return for the market since the Great Depression. So, it would not be irrational to think that history could repeat itself as it so often does.

Figure 1

Figure 2

While we may see a strong run going into the end of the year, there are still various economic pressures that have caught our attention as we move into next year. Further bank and private de-leveraging would lead to tighter credit markets and less consumer spending. Such bank actions are possible as we are witnessing delinquency rates within residential, commercial and credit cards at 15 year highs. Of those three credit card delinquencies are the only one that have started to level off. Both commercial and residential bank loan delinquencies have been consistently rising. Rising loan delinquencies cause banks to tighten lending standards, in turn, taking money out of the economy, which would inhibit expansionary activities such as home purchases and business investments. The September 8th, 2009 consumer credit report showed a drop in consumer credit by an annual rate of 10.4%. In percentage terms, the drop in credit is the biggest since June 1975. And on a year-on-year basis, credit is down 4.3%, the biggest drop since June 1944. This report is clear evidence that consumers are “hunkering down”. Instead of making new purchases they are paying off. Since approximately 70% of the U.S. economy is consumer driven the evidence that private citizens are de-leveraging could have negative effects on the economy. I personally believe that consumer de-leveraging is a good thing long-term for personal balance sheets since Americans are so strapped with debt, but while the de-leveraging process is taking place money that would be used to make purchases is being used to pay off debt and that has a negative effect on consumption.

Going forward the U.S. administration along with the Federal Reserve Board is going to have some very difficult choices to make. Currently the government is faced with sharply declining corporate and private tax revenues. At the same time the government is spending record amounts to boost the economy and bailout failing companies. Declining revenues and increased expenses has caused record deficits. The administration has projected a $1.58 trillion deficit for 2009 and $9 trillion over next the next ten years. Our current U.S. national debt is over $11.8 trillion (see http://www.usdebtclock.org/ for a jaw-dropping look at these numbers in real-time). These massive deficits will be added to our already astronomical debt. There lies the difficult decision that the administration has to make. The three most likely paths they will take are to: 1) raise taxes to increase tax revenues which would probably cause the economy to slow down and further raise unemployment over the current reading of 9.7%; 2) raise the Federal Reserve rate which would tend to support the dollar thereby fight inflation but this would also slow the economy or 3) not do anything and potentially allow inflation to run out of control. So, as you can see the administration is in a catch-22.

Although the administration has its hands full, we do believe there are opportunities out there that we are currently taking advantage of and we also believe that as we go forward into the next year there are going to be more opportunities created. One clear opportunity that we have capitalized on and we believe still has a further move higher is in the commodity markets in general, but especially in gold, gold miners, oil and natural gas. As stock markets around the world dropped over 50% during their recent decline some commodity sectors fell over 80%, which has provided some irrationally low price levels for us to take advantage of. We believe that these sectors will have longer lasting and higher percentage returns than the general equities market. It has become more apparent in recent years that emerging markets are no longer just a small sub-sector of the world economy. But, instead we believe that the emerging countries around the world like China, India, Brazil, Russia, some African and Middle Eastern countries along with other Asian and South American countries will be major drivers of the world economy. This could be the catalyst over the next couple of decades that could reign in new times of economic prosperity. Although we believe the next few years could be difficult looking forward we will be keeping an eye on the growth and increasing influence of the emerging and frontier economies.

If the market does start to get shaky late this year or sometime next year, we will attempt to rotate assets out of some equities and into certain assets that tend to go up when the general markets go down. Assets such as long-term Treasuries, extended duration U.S. debt and other hedging assets that traditionally do well in a “flight to safety” scenario. In times like these it is very important to be able to go defensive when the time calls and to go aggressive when the opportunities present themselves. Although it may seem like rough roads ahead we believe these type of extreme fear and greed driven markets present the best intermediate term opportunities if you are able to navigate the waters correctly.

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Swine Flu and the Reality

Posted on 29 April 2009 by Allgen Financial

If anyone has watched the news in the last six months, things would appear to be apocalyptic.  Some of the main headlines you would have witnessed would be ”Credit Crisis”, “Record Foreclosures”,  “Bernie Madoff – Biggest Ponzi Scheme of all Time”, “Greatest Stock Market fall since the Great Depression”, “25 Year Highs in Unemployment”, “Massive Bank Failures”, “401k’s Down 50%+” and the latest…”Swine-Flu Pandemic”.  That’s enough to make a person feel like the world is coming to an end.  In fact, many people are convinced we are approaching the “end of times” - there are close to 1 billion searches on Google for some variation of an “end of times” scenario.  I won’t try to sugar coat what has occurred over the last year or so as the world has gone through some difficult times, but I will highlight some positives that you rarely hear in the main stream media.  For starters, did you know the over the last month there was a 15 day period where the S&P 500 had it’s biggest rally since the Great Depression?  In fact, since the recent low in the market the S&P 500 is up over 25% and the NASDAQ is up over 32%.

Here are some things to keep in mind as you listen to some of your family, friends and most importantly the main stream media.  Media outlets gain higher ratings over panic-type news so it is only logical for them to exaggerate any story.  This causes a chain reaction that develops into a negative feed-back loop.  As people hear the story’s from the media of mass losses in the stock market, rising unemployment, bank failures, etc. combined with actual experiences of losses or hearing from a friend or family member of losses or hardships that they’ve experienced this will cause people to believe things are worse than they actually are.  Remember that this happens on a massive scale and will create what’s called herd-like behavior.  Then, after the “herd” processes all the information they will tend to do the opposite of what the “bigger”, “smarter” money does – they sell their stocks and go defensive.  Unfortunately the herd is usually wrong and almost always wrong at extreme points in the history of the stock market (I would consider recent times as an extreme point).  When fear is at its highest point the market usually bottoms. This phenomenon occurs because the herd acts on the present and the past and the “smart” money acts on the perceived future.  The “smart” money takes advantage of the panic and of the herd by buying stocks after the panic selling, which gives the smart money the chance to buy low.  The same mentality happens at market peaks, as well.  When everything seems to be going great and the media continues to highlight how great the market is doing (like the tech bubble in the late 90’s), that is when the “smart” money is selling and becoming defensive and unfortunately that is when the herd is buying into stocks.

Some measurements of fear that we track have recently hit 21 year highs and even after the markets recent sharp rally fear indicators are still measuring at extremely high levels.  Most would think this is a bad thing, but I’m telling you that this is a positive and a reason to believe the market could go much higher from here.  On top of that the pundits in the main-stream media doubt this rally and most are saying that the market will come back down.  This too, is a positive, as the herd is usually wrong at extreme points throughout history.  As most of the herd has recently gone defensive, Allgen has been aggressively buying over the last month to take advantage of the recent rally and the high potential for future gains.  History has shown that the biggest market rallies follow the biggest market drops; unfortunately the herd is usually late to the party and won’t participate in the majority of the gains.

Going forward our advice is to be skeptical of what the media is saying and what the herd is doing especially at extreme points in time.  History shows that you’re usually better off doing the opposite of what the herd does.

Written By:
Jason Martin, CMT & CFP
Chief Investment Officer
Allgen Financial Services, Inc.

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High Volume Reversal Day in the Stock Market 02-05-09

Posted on 05 February 2009 by Allgen Financial

Before the market opened today there was a very weak jobs report.  The market initially reacted negatively to this report and to the fear of more potential bank failures.  Bank of America at one point of the morning got as low as $3.77, down almost 20%!  The Dow Jones Industrial Average had broken below support and it appeared that the market was ready to go into a new freefall that could of lead to huge losses.  But, at around 10:30am the market decided it had gone down low enough and the market began to reverse and head higher.  By the end of the day the market had rallied about 3% from it’s lows to post a decent gain on high volume. And Bank of America rallied approximately 30% from it’s lows to close up around 6% on the day.  Psychologically if the market rallies on bad news it is considered positively constructive action.  Because it means the market is looking forward to potential improvements while at the same time shrugging off or discounting current economic bad news.  It is important to know that the market leads the economy and almost always starts to go into a new bull market before the economy improves.

The NASDAQ (pictured below) was the clear leader today.  It posted the highest volume day in nearly 2 months which adds validity to today’s move.  From a longer-term point of view the NASDAQ along with the other major U.S. indices have formed a potential upside-down Head & Shoulders pattern.  The significance of this pattern is if the NASDAQ is able to close above the blue downward sloping trend-line that is drawn in this picture at around the level of 1600 that would significantly improve the NASDAQ and the other markets probability of a reversal in the current down trend.  Some individual sectors like the Bio-Techs, Semi-Conductors and Software indices have already broken above this reversal pattern.  These sectors are providing something the market has lacked for a long time…Leadership!  Today’s action does not eliminate the possibility for further downside moves; it simply means that it was one positive day and a step in the right direction.

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Signs of Investors Taking More Risk

Posted on 26 January 2009 by Allgen Financial

As investors lick their wounds from last years horrid stock market declines there are signs some investors are dusting themselves off and hopping back on the horse.  In the last quarter of 2008, investors were scrambling to get into safe havens like cash, money markets and treasuries.   The chart featured in this article is a chart of the iShares Lehman 20+ Year Treasury Bond (TLT).  This exchange traded fund corresponds very closely to longer term treasury prices.  Treasuries are considered a safe haven and as you can see in the chart as interest rates came down last year and has investors flocked to safety this fund appreciated.  Since the start of the year money has been coming out of treasuries, which I consider a good sign.  As investors sell out of treasuries this usually means that investors are willing to take on more risk and are looking outside of treasuries to find higher returns (ie. stock market or bond market).  This could help the stock market going forward.

Treasuries declining are one sign that fear has been subsiding another sign is found a sentiment indicator called the Volatility Indicator VIX (aka fear indicator).  As the market hit the lows back in November of last year the VIX got as high as 89.53, which by the way was the highest reading since the 21-year old indicator has been in existence.  In the markets most recent decline last week which took the market down close to the November lows of last year the VIX only got as high as 57.36, far less than the November highs of last year.  Going forward this doesn’t mean that the market is going to go into a bull market, but these signs are encouraging and could eventually lead to greater confidence in the stock market which could lead to a rise in stock prices.

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