Weighing The Week Ahead: What Is Your Course For Uncharted Waters?

The Calendar

The calendar is light, and we have a holiday-shortened week. The government shutdown will probably affect the home sales reports, but probably not Consumer Confidence. The shutdown will probably also affect next week’s scheduled employment report.

Briefing.com has a good U.S. economic calendar for the week. Here are the main U.S. releases.

Next Week’s Theme

Following my plan to highlight what is most important and hope that the punditry joins in, I want to discuss the most important current investor questions. In general, they take the form of “what next?” Everyone needs a plan.

How should you navigate these uncharted waters?

There are three important questions: What is happening? When will it stop? How should I plan?

What is happening?

Not what you hear on the daily news. Those stories say things like “Investors showed renewed global growth fears and resumed selling.” Or “Bulls were in full retreat, unable to defend support at….”

Turning the market into the decisions of “investors” and attaching a reason makes for a simple story. So does describing a game between bulls and bears. Both are simplistic and unhelpful for genuine analysis.

Morgan Housel writes about Investing Ideas that Changed My Life. The entire post is great, but here is the part most relevant to our current purpose:

Markets have to be pushed to crazy extremes once in a while, but it’s never as crazy as it looks. It’s the result of five innocent things playing out:

  • Investors have different time horizons. Day traders, generational buy-and-holders, and everything in between.
  • Each group tries to exploit profit opportunities within their own timeframe.
  • Short-term investors are often after momentum. They can reasonably chase prices higher even when those prices are detached from a business’s intrinsic value.
  • Sometimes that momentum, and those profits are strong enough to capture the attention of investors with longer time horizons whose strategy relies on businesses trading at or near their intrinsic value.
  • Things get crazy when the actions of long-term investors playing one game become influenced by the actions of short-term investors who are playing a different game and appear to know something the long-termers don’t. The long-termers usually don’t realize this, which is why the process is both innocent and bewildering, even in hindsight.

Current trading is dominated by those trading “fast,” perhaps 80% of the volume. I have written about some of these groups but let me flesh it out a bit with players in evidence this week.

  • HFT algorithms. This is super-short term, triggered by a few words in a news story that you have not even seen yet.
  • Factor systems, emphasizing characteristics like momentum, price, or quality. Popularity often leads to a crowded trade and a simultaneous desire to sell.
  • Technical analysis-based systems. Once again, many traders get buy or sell signals at exactly the same time.
  • Fund redemptions. Mutual funds that anticipate redemptions need cash to meet them.
  • Fund liquidation. Failing funds face forced selling. Some of last week’s trading had that look, sparking some rumors. Aggressive managers use leverage based upon a normal range of outcomes. They are caught off base when there is a move of several standard deviations.

The first two elements are relatively new, perhaps changing the nature of other market signals. The danger to the average investor is that this trading is treated as meaningful and important, just as Morgan is saying in the quotation above.

When will it stop?

No one can provide a specific answer, but here are some important factors.

Sentiment. David Templeton (HORAN) covers several important sentiment indicators. Strongly negative sentiment is associated with “capitulation” and market bottoms. Here are two examples – the elevated put-call ratio (2 is normal) and the Fear and Greed Index.

Earnings Season. We will have to wait until January, but it may provide the key catalyst. Trader expectations are that estimates will fall.

Post-holiday action by big investment funds. This is not “hot money” reacting to each tweet and new phrase from the Fed. There are investment committees with reports from well-prepared participants. Asset allocation is reviewed. We can expect lower stock prices to attract larger allocations.

What Should We Do?

The answer depends on individual objectives and time frame. In each case, you should already have a plan. Market declines in this range are a regular part of investing. We just haven’t seen one in a few years. Enjoying the rewards of investing always involves some level of risk. A good plan limits that risk to a manageable level.

  1. Implement your plan. You created it in advance without emotion. If your trading has specific stops, that is one answer. If you are confident of your overall portfolio allocation and have plenty of time, you have planned to ride it out, even if there is a recession. My own plan includes exiting from trading programs when we get the “storm signal” described in our quant section. I reduce long-term holdings if recession risk or the SLFSI rises. Having a plan like this helps us know the limit of possible losses.
  2. No plan in place? Make one. While it is difficult to do during turmoil, it is no less necessary. If you cannot do this yourself, get help! It is important.
  3. Separate fundamental analysis from the emotion of the market. None of the proven recession models is showing a near-term threat. The SLFSI is solidly in low-risk territory. Economic data and earnings remain at high levels. If you have some cash, you can do some buying. It does not have to be all-in. If you are fully invested, you might do like the big boys – get a little more aggressive in your asset allocation when stocks are cheap. Don’t forget to rebalance if circumstances change.
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