Flickr: B Rosen’s Shutter
As the markets start off February with a decline, investors are starting to worry about the markets.
I have been finishing up this month’s research topic and wanted to share a few thoughts to those who don’t want to read a lengthy research report.
First off, our ARTAIS models have been on a sell signal for equities. This started back in December when emerging markets started to raise a few warning flags.
Emerging Markets (EEM)
S&P 500 (weekly):
200 Day Moving Average Is Still Intact
However, the S&P 500 index is still above the 200 day moving average (SMA) – this is a good sign for investors.
Why the 200 day moving average matters:
This is a “line in the sand” for many investors. In fact, studies have shown that market volatility in 30% higher when the S&P 500 index trades below it’s 200 day moving average.
In his 2006 book, Stocks for the Long Run, Jeremy Siegal studied the Dow Jones Industrial Average (DJIA) from 1886 to 2006 and found that the 200 day moving average provided a way for investors to reduce volatility in their portfolios and increase returns by avoiding stocks when they trade below this indicator.
More recently, Mebane Faber’s paper, A Quantitative Approach to Tactical Asset Allocation studies the use of moving averages and found similar results using a 10 month moving average:
Additionally, this strategy was able to avoid most of the 2008 stock market decline:
Investors Are VERY Leveraged
Market volatility in 2014 has increased as expected. With a combination of high investor borrowing rates and a Fed slowing down the stimulus “throttle”, investors are becoming a bit more timid than in 2013.
One key data point that I am keeping an eye on is investor margin levels.
As the margin levels in investors’ portfolios have surpassed the peaks levels of 2000 and 2007, investors are starting to worry that without the Fed pushing 100% on the gas, the global markets will pull back.
High margin balances could quickly impact the markets as investors rush to the exits as they begin to de-leverage their portfolios:
Reversal of Bond Outflows?
Some of the recent market declines may be due to portfolio reallocations. Last year was the first time since 2008 in which investors preferred equities over bonds:
With the rise in volatility we may be seeing investors swapping back into bonds.
In fact, our models have been showing a few buy signals for US bonds (TLT):
To me, this all makes sense since the Fed is taking their foot off gas and the correlation between the stock market and the Fed has been very high since 2008:
Key Areas To Watch
1) Watch the equity markets as the S&P 500’s 200 moving day average is approached. Investors can get great insight to what the rest of the market is thinking by looking to see if other investors panic, or view this “line in the sand” as a buying opportunity.
2) Watch bond inflows – are global investors becoming more worried about what the world will look like without a Fed who has the gas pedal pressed to the floor? Investors typically view US Treasury bonds as safe heaven investments in times of trouble. A spike in bond inflows may indicate an increase in investor worry.
3) Lastly, watch volatility levels. Investors have been treated to very low levels of volatility for the past two years. A continued high level may be too much for investors who are carrying large margin balances to handle.
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