How To Make Choppy Markets Work For You, Not Against You

I have made it a habit to post the monthly and long termed performance numbers of our ValueTrend model equity platform on our website (www.valuetrend.ca). The performance is compared to a “North American Index”, which is a compilation of the TSX 300 and S&P 500 indices. By doing this, we are exposing ourselves to criticism should we underperform —even if it’s just for a short period of time. Perhaps that’s the reason why many portfolio managers choose to avoid publicly posting their results—it’s not pleasant to show the world your goods when things aren’t going as well as you’d like.

We had such a period of underperformance back in 2012. We took a bearish stance that summer due to political events (Italy/Spain/Greece concerns, and US Federal Reserve policy uncertainties). Instead of being choppy, markets actually experienced the majority of their gains over the very period when we were most cautious.

Periods of underperformance happen to the best of us, and that year we suffered the ego-crushing experience of posting our poor numbers for the world to see. Nonetheless, if your strategy is more often right than wrong, you will win over the longer term. Our performance picked up drastically after 2012.  This allowed us to make up for that one crummy year. In fact, we’ve outperformed the markets sizably both before and since that poor performing year, allowing us to post long-termed winning numbers. It’s a lesson for any investor to understand: just because you’ve had a bad year, it doesn’t mean your system no longer works.

One of the ways that we have managed to provide our clients with above-average returns and below-average risk has been through selling when markets look ready to correct. And now is one of those times. We believe that the stock markets are overdue for a correction—one that will likely occur by the fall. Several pieces of evidence add to this opinion:

The Shiller inflation-adjusted PE ratio is over 27 X trailing earnings, a level that has historically proceeded corrections;

Corrections of 20% + are normal for a healthy stock market. The US markets have not had such a move since the summer of 2011. The five year bull/bear cycle and common sense suggest we are due for a significant correction;

Presidential electoral cycles suggest strength in the first half of a pre-election year (2015 is such a year), followed by a weaker second half. So far, that seems the case – given the sideways range over the past quarter;

Volatility has increased from the 4th quarter of 2014 into the current year. This can be a sign of a market transition from up trending to corrective action. Again, the current range bound markets are another potential sign of such a transition;

The Canadian economy is faltering and will continue to falter in the face of weak oil prices (which will eventually recover, but not to their old highs any time soon). Thus, the Canadian dollar will remain weak, and our bond yields will stay low for the time being;

The Dow Theory contains a tenet suggesting the Dow Transportation index must confirm the highs and direction of the Industrials. We are currently witnessing a divergence in the direction of the Transports vs. the Industrials. The DJTI has been moving down since February. So too has the TSX Transports Index, which has experienced an even greater pullback. Despite the theory’s faults (it tends to either lag or lead a correction by long time periods), the indicator has rarely missed a market correction when Transports diverge as they are now.

Ignore the above market signals at your own peril.

How To Limit Your Risk

Whether markets translate the above factors into a 20% correction, or just a continuation of the volatile, meandering markets we've seen since the beginning of the year, I remain cautious. We're at 40% + cash in our ValueTrend equity model now—and have been since spring. That has saved us from the rather bearish trends of late, especially in light of the situation in Greece, China, commodities, etc. In fact, I’m happy to report that our equity model has achieved a positive return since the beginning of the year (January 1- June 30) while markets across North America (Canada, US) and the world are struggling.

At ValueTrend, we took action on the cautious signals mentioned above. As noted above, we raised cash by selling some of our more growth-oriented stocks.  We also began focusing part of our holdings within interest-sensitive stocks such as Cominar REIT CUF.UN-T and SPDR utilities XLU-US to the mix. And we also rotated out of some of our consumer discretionary holdings into the consumer staples sector (SPDR Consumer Staples XLP-US).

Our plan is to stay in a fair chunk of cash for the greater part of the summer. We may use the current volatility to buy select positions we’ve been monitoring – but we’ll play that by ear. Picking your entry points is a mugs game in a volatile market such as this, so we want to remain cautious. One way or another, we expect that this summer/fall will present a fantastic buying opportunity. We followed this exact strategy in the summer of 2011 when markets last corrected by over 20% (holding cash), and it worked to our benefit—just as it is now. We expect that our portfolio will continue to beat the market at its own game and will reap the benefits of our cautious stance. I hope that you are following a similar strategy.

One final thought. Please be patient: markets will rise and fall on hope and fear as political and other events unfold this summer. Don’t get caught up in this nonsense. For patient investors willing to hold a bit of cash and leap on the opportunities when they appear, I believe that this will turn out to be a spectacular buying opportunity—just as it was for us in 2011. But you need to have some cash to take advantage of soft markets. 

In my next column I will put together a list of “watch” candidates that investors seeking an opportunistic play in the coming months can consider for their portfolios.

Keith Richards, Portfolio Manager, can be contacted at krichards@valuetrend.ca.  He may hold positions in the securities mentioned. Worldsource Securities Inc. – Member: Canadian Investor Protection Fund, and sponsoring investment dealer of Keith Richards.

The opinions expressed are those solely of Keith Richards and may not necessarily reflect that of Worldsource Securities, its employees or affiliates. The contents are for information purposes only and do not represent investment advice. ETFs may have exposure to aggressive investment techniques that include leveraging, which magnify gains and losses and can result in greater volatility in value, and be subject to aggressive investment risk and price volatility risk. ETFs are not guaranteed, their values change frequently and past performance may not be repeated. Please read the prospectus before investing.