Preparing For Possibility Of Uncomfortable Allocation Shifts

Flexibility in the markets sounds rational and fairly easy until egos and human emotion come into play. First, let’s examine why the current market is a bit odd and somewhat rare. Then, we will cover some important tenets of success that apply to this market and all markets.

Flat Momentum Means Things Can Change Rapidly

The chart below helps us answer “would I rather be in stocks ($SPX) or would I rather be in bonds (AGG)?” AGG is a diversified basket of fixed income instruments (think total bond market). The weekly trend, monitored with the blue and red moving averages, still says “I’d rather be in stocks.” However, the flat momentum, measured by the Slow STO indicator, tells us that investors are indecisive and the trend is vulnerable to a reversal.

As we noted this week, vulnerable does not mean bearish. It means the odds of flipping to a bearish profile have increased. Stockcharts.com describes a stochastic oscillator this way:

Developed by George C. Lane in the late 1950s, the Stochastic Oscillator is a momentum indicator that shows the location of the close relative to the high-low range over a set number of periods. According to an interview with Lane, the Stochastic Oscillator “doesn’t follow price, it doesn’t follow volume or anything like that. It follows the speed or the momentum of price. As a rule, the momentum changes direction before price.”

Binary Answers Can Flip Rapidly In Both Directions

Let’s assume we ask three questions about the SLOW STO indicator:

  1. Is black above red?
  2. Is the slope of black positive?
  3. Is the slope of red positive?

When the black and red lines are flat and on top of each other, as they are now, the answers to the questions above can rapidly move from YES, YES, YES to NO, NO, NO, which is typically not the case. That’s the bad news in terms of staying allocated with the market’s current profile. The good news is if we stick to our discipline and follow the rules, the market will eventually make a more definitive and longer-lasting move either up or down, allowing us to stay properly allocated with the market’s risk profile. Flat momentum means our allocations can shift fairly rapidly in a bullish or bearish direction. It is important to understand that is the exception, not the rule. Typically, market conviction is more definitively in the bullish or bearish camp, and thus, the momentum oscillators have a positive or negative slope, meaning they do not flip from YES, YES, YES to NO, NO, NO in a matter of days, and then back again in a matter of days (as they may currently).

Ego Cannot Enter The Decision Making Process

We are all human. We all like to be right. No one likes to cut stock exposure, and then quickly increase stock exposure, only to cut it again soon thereafter, which is what can happen when markets are very indecisive and momentum is flat as it is now. We would prefer to properly manage risk and get properly aligned with the market looking out several weeks, rather than worry about looking smart or minimizing the number of allocation shifts. If we want to end up in the right place, we have to push our ego aside and be willing to complete some uncomfortable tasks in the short run, which is exactly what we will do, and we will do so without hesitating. The last sentence sounds rational, but it requires confidence in your system and a firm resolve to properly manage risk and reward.

Sleeping Better At Night

Our approach to the markets focuses on probabilistic reward relative to probabilistic risk, which is a complex way of saying we want to put our capital in harm’s way when the odds are in our favor and reduce risk when the odds begin to deteriorate. The key to sleeping better at night and improving our odds of long-term success are:

  1. Stay aligned with the market’s current profile and you will never stray too far from a prudent investment allocation between growth assets and conservative assets.
  2. Have a short memory. Our system acknowledges in advance that some incremental moves will be wrong. If that last incremental chess move was based on the evidence and the rules, do not second guess the move if the market quickly shifts the other way.
  3. The objective is to “get it right” looking out several weeks or several months, not several days.
  4. All systems struggle at times. The key is to continue to follow the system and rules 100% of the time, since it is the best way to be successful in the long run.

If you have to be right 100% of the time, then the financial markets are not a good place to spend your time. We can control the decisions we make based on the evidence we have in hand. We cannot control how the evidence changes over the coming days or weeks.

Many Charts And Indicators Have Similar Looks

A logical pushback might be “the stock vs. bond chart is currently skewed by fears of rising interest rates.” That is true, but we could show you numerous markets and ratios that have almost identical and flat momentum indicators on weekly charts. The widespread “SLO MO” evidence tells us to remain flexible, stay with our discipline, and leave our egos at home. If we do that, we will look back in a few weeks (or months) and be able to say we are properly aligned with the evidence in hand.

Where Are We Now?

Are we currently allocated based on the evidence in hand? Yes, we are right on the money based on the intraweek rules.


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