I have conducted detailed studies of market behavior in various time periods. One of these periods was early 2016, a volatile market environment in which stocks experienced a sharp 10% correction, followed by a recovery.
The first quarter of 2016 was a very difficult one for many fund managers, according to an article in the Financial Times (“Investors Rake Over Ashes of a Dismal Quarter,” April 5, 2016). In fact the article cites data to the effect that it was one of the worst quarters in recent history for active managers, with the vast majority underperforming their benchmarks.
The article states, “They were simply wrong about the direction of the economy, and therefore markets… fund managers were in exactly the wrong sectors… By the time the market bounced and reversed, many fund managers had given up their more bullish cyclical bets, and missed out again.”
“There was a problem for the momentum strategy… many had piled into a few high momentum winners… Almost nothing worked during both halves of the quarter except valuation, a now out of vogue attribute… The median return of the 11 most popular stocks held by hedge funds, according to Mr. Kostin, was minus 10%.”
“Another problem came with beta. A high-beta stock is unusually sensitive to the overall market… This year, that strategy failed spectacularly… Add a difficult market to an economic climate that took many investors by surprise, and then add the collapse of some crude strategies that many managers use… and you get the disaster that was the first quarter.”
My research shows that it is possible to successfully analyze such situations and make logical investment decisions that result in good investment performance. This can be done with a combination of technical and fundamental analysis. Also we can make decisions on sector weights and stock selection by using a set of rules or guidelines specifying what actions to take when market conditions change.
This is discussed in the following excerpts from my report “A Comprehensive Approach to Equity Market Analysis.” (Note: the following paragraphs are just excerpts, they are not the complete report.)
… Let us take a look at how the methodology outlined in this report handled sector rotation and stock selection in the first quarter of 2016.
We will look at the following questions:
1) How could we have known to move to a defensive investment posture in December 2015 or early January 2016, shifting client portfolios with a reduction in equity exposure and / or a move into defensive sectors such as utilities and consumer staples?
2) How could we have known to move back to a more aggressive posture in mid-February 2016, with an increase in equity exposure and / or a move into high-beta sectors?
A. General Market Conditions
By year-end 2015 the condition of the stock market was not terrible, but it was becoming increasingly worrisome, for the following reasons:
1. Oil prices, high yield bonds, and emerging markets were breaking down to new lows. These markets were in clear downtrends with no signs of a bottom yet, and their weakness was putting downward pressure on stocks, as these asset classes were connected by the fundamentals.
2. U.S. equity indices were displaying bearish patterns:
a. Sharp selloffs on heavy volume
b. Selloffs falling through support levels, rallies ending at resistance levels
c. Lower highs and lower lows
3. Group rotation showed that energy and basic materials were plunging. The only sectors acting well were safe havens such as consumer staples and utilities.
As January 2016 began, markets dropped sharply, sparked by worrisome geopolitical news including North Korea testing a hydrogen bomb, and Saudi Arabia cutting diplomatic ties with Iran.
Figure 18 S&P 500 (SPY) daily December 2015 – March 2016 — forms a Double Bottom
Mid-February 2016 – Market hits bottom and new uptrend starts
In mid-February the S&P 500 retested its January low (see Figure 18). Instead of breaking down to a new low, on 2/11/16 it stopped going down at almost exactly the same level. Then it rallied, beginning with a gap up on 2/12/16. This was a significant event, showing that buyers had come in at the support level.
The market continued to rise over the next few days, providing further confirmation that a double bottom was in place. Investor’s Business Daily (investors.com) stated that 2/17/16 was a “follow through day” or the type of trading day which confirmed that the correction was over and a new uptrend had begun.
Given these circumstances, conditions were right to do some buying in mid-February 2016. The market was showing a surge of institutional buying pressure, but it was not overbought yet, in fact it was just coming up from being oversold.
In such circumstances, buying could be done either immediately or over the following weeks, as new market leadership emerged. There are ways to determine what stocks should be bought, as will be discussed below.
Market conditions could now be categorized in the “Uptrend Starts” category. Thus we refer to the playbook to see what actions should be taken. Under these conditions, the playbook says the following:
1. Asset allocation –
a. Put cash to work — increase equity exposure
b. Reduce positions in asset classes that have negative correlations to equities, such as bonds or gold
2. Sector rotation –
a. Move out of safe haven groups
b. Look for stocks that have become extremely oversold – they may make a sharp rebound from their oversold condition when the market turns up
c. Look for new emerging leadership – such as stocks that made a higher low as the market made the second low of its double bottom
d. Look for stocks that were in ideal technical positions just before the market selloff began, but then were dragged down by the correction – especially if they show signs of renewed institutional buying (see the discussion of NVDA below).
In this case the asset allocation decision was clear, because stocks were oversold and bouncing up from support. In general, when the market has formed a bottom and starts to make a strong rebound from an oversold condition, the risk / reward ratio is very favorable, and provides a good opportunity to be aggressive and make money, perhaps using leveraged ETFs or similar vehicles.
For example, SPXL, the triple long S&P 500 ETF, gained 34% in seven weeks from 2/12/16 – 3/31/16. A good part of the performance for an entire year may be generated by making the right moves in this type of environment.
Even if we do not make any changes in asset allocation, this analysis can have major implications for sector rotation and stock selection, as will be discussed below.
Stock selection
… As mentioned above, another valuable tactic is to look for stocks that were in ideal technical positions just before the correction began, but then were dragged down by the market selloff – especially if they show signs of renewed institutional buying as the market rebounds.
Semiconductor stock Nvidia (NVDA) had broken out to a new high in October 2015, and in late 2015 it made a strong move up on big volume with strong money flow (see Figure 10 below). In late December 2015, it was forming its first pullback to its 50-day moving average, which in a normal market environment would be a good buying opportunity.
However it was then dragged down by the sharp market correction which occurred in early 2016. This is shown in the following chart.
Figure 10 NVDA – Weekly chart – an attractive buy candidate in early 2016
Figure 11 NVDA – Daily Chart – Early 2016
As the market rebounded in mid-February 2016, NVDA shot higher with a dramatic gap up on huge volume, indicating major institutional buying coming into the stock (Figure 11).
Following these bullish developments, the stock rose sharply over the next few months (as seen in Figure 10), and eventually went much higher over the next few years.
This shows the value of a rule-based approach, in which first we analyze the market condition, then use the appropriate tactics for stock selection. In this case the market condition could be categorized as “correction has ended, uptrend starts.”
In this situation, one of our investment rules is: “Look for stocks that were in ideal technical positions just before the correction began, but then were dragged down by the correction – especially if they show signs of renewed institutional buying as the market recovers.”
My research shows that this type of logical, top-down, rule-based process can be very effective, and can lead to good investment performance in difficult market environments.