Bearish investors like us have a problem


Just to clarify:

  1. The optimal decision right now is to follow our model to the letter and be 100% long UPRO (3x S&P 500 ETF). Our model only predicts bear markets and significant corrections. The optimal decision is to ignore all small corrections because it’s not possible to consistently predict when a small correction will start.
  2. We have gone against our model and shifted to 100% cash. In doing so, we are reducing our potential returns but also reducing our portfolio’s risk/volatility.
  3. This is one of the longest “small rallies” of all time. The S&P will make a small correction sometime in 2017. That will be a great buying opportunity.
  4. We are up 17% year-to-date. If we can buy UPRO when the S&P fells 6%, our portfolio will be up 40% for 2017. Not a bad year at all.

We have no idea if the small correction will start right now. Perhaps it will start in July, or perhaps it will start in August, or perhaps it will start in September. Who knows.
But there is a convincing case that the S&P won’t begin a small correction right now. Perhaps the S&P will rally into July’s earnings season or August before starting a small correction.

Look at the S&P’s sectors

Index investors need to look at the S&P’s 11 sectors. Only 3 sectors matter: energy, finance, and tech.

  1. Tech and finance are the 2 biggest sectors.
  2. Energy is a smaller sector. However, it is very volatile, which means that it has an outsized impact on the S&P.

Over the past few months…
Over the past few months, the energy and financial sectors have been putting downwards pressure on the S&P 500. XLE (energy sector ETF) has been falling because oil prices have been weak. XLF (finance sector ETF) has been falling because interest rates have been falling.
Meanwhile, the S&P has soared to new all time highs!
Here is the S&P in 2017.

Here’s XLE in 2017.

Here is XLF in 2017:

We examined this divergence. A month ago we did a study which showed that the XLE’s divergence with the S&P will drag the S&P 500 down and into a small correction.
However, there is a caveat. When this divergence lasts too long, it is no longer a bearish factor. It is a bullish factor. (See post here)
Think about it this way. Since the beginning of March, XLF has fallen 8% and XLE has fallen 10%. Meanwhile, the S&P has gone up 1%! (The S&P has been lifted up by tech). The bearish pressure from these 2 sectors couldn’t push the S&P down! Imagine what the S&P will do if these two bearish factors are removed.
The finance sector doesn’t have a lot of room left to fall. The COT Report is extremely bullish on rates. The smart money hedgers are extremely bearish on bonds (bullish on rates).

If rates can’t fall much more, it’s hard to see why oil prices should tank to e.g. $40. There is still an overall positive correlation between rates and oil right now.
So if the finance and energy sectors are close to hitting bottom, then they are no longer bearish factors for the S&P. They are bullish factors! This is “sector rotation”.
The tech sector does not typically cause corrections. Tech merely reacts to the S&P’s corrections. In other words, it’s hard for tech to fall while finance and energy rally.
We mentioned yesterday that Amazon is unlikely to top here at $1000.

Bottom line

Investors like us who are sitting on cash will probably need to be a bit more patient.

2 comments add yours

  1. Why are you bearish then Troy? If the market moves up another 7% and then declines 6% “the small correction” you are expecting, wouldn’t you be better off staying invested. Also, how long were you 100% cash? What’s the opportunity cost so far while the index has been moving up – you should calculate from the point you went into all cash. Also, curious why you went against your own model?!

    • The S&P might not first move up 7%. It might first move up 2%, or 3%, or 4%, or 5% etc. Who knows.
      We’ve been 100% cash for less than a month (around 2393).

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