Why we're selling stocks: there are too many short and medium term risks

*After a long discussion with our team, we have decided to slightly alter our investment strategy. Read the updated Our Model page for more details. In essence, we will override our model from time to time and make discretionary investment decisions. Our model is not perfect. Discretionary overrides will reduce our return because we will be on the sidelines for some of the rallies. However, we will also drastically reduce our risk and our portfolio’s short term volatility. We still only invest in UPRO (3x ETF for the S&P 500).
This is discretionary override. We will sell all of our UPRO and shift to cash on Monday’s opening bell.

Why we can afford to sit on the sidelines

Year to date, our portfolio is up around 17%! We have been 3x leveraged to the S&P 500 for most of the time. We are very close to hitting our annual performance guideline of 20%. So we can afford to rest on our laurels while global markets face short term risks.

Why we’re bearish on the U.S. stock market

There are too many short term bearish factors and risks right now. These will probably cause a small correction right now (minimum 6% decline from top to bottom). If the problems deteriorate significantly, the small correction might make a big correction. We still think that a small correction is the most likely scenario, but we’ll reassess the situation as time goes on.
And even if the S&P rises before it begins a small correction, who cares!

  1. The risk:reward profile does not favor bulls right now.
  2. Let’s assume the S&P rises 6%. That brings it to approximately 2540. Then a 6% small correction will bring the S&P down to 2387. In other words, the S&P will still fall back to our selling price even if it first rises 6%!

Risk #1: our model
Our significant correction model is aided by a backup indicator. This backup indicator predicts significant corrections and bear markets as the market is falling. For example, it might predict the the S&P will fall 18% after it has already fallen 5%.
We have a problem right now. Our model does not see a significant correction on the horizon. And in order for the backup indicator to be triggered (i.e. tell us to SELL), the S&P has to fall a LOT right now. This renders the backup indicator semi-useless in this case. There’s no point in having the backup indicator tell us that the market will fall another 7% after it has already fallen 9-10%. By then it’ll be too late.
If the U.S. economy deteriorates in September-October 2017, this backup indicator will be triggered. Although we don’t think the U.S. economy will deteriorate, perhaps we are wrong.
Risk #2: the U.S. stock market’s own short term problems
These problems all support a small correction for the S&P 500 right now.

  1. XLE (energy sector ETF) will continue to fall if oil continues to fall. Oil’s supply is soaring right now, which puts bearish pressure on oil prices. In addition, XLE has already fallen a lot over the past few months while the S&P has risen. As we’ve demonstrated in a study, most XLE declines precede the S&P’s small corrections.
  2. This is one of the longest rallies in history between 2 small corrections. Only the rally of 1995 has been longer. So from a TIME perspective, a small correction is long overdue.
  3. U.S. economic data has deteriorated a little in the past month. There is a small positive correlation between changes in the economic data and short term changes in the S&P 500.

Risk #3: external medium term risks
We have been talking to a lot of other successful traders and funds recently. All of their thoughts point to the same conclusions.
U.S. dollar
“The U.S. dollar’s bull market is not over, and it might go much higher.”
Right now, most investors think that the U.S. dollar is in a bear market and the Euro is in a bull market. The price action says otherwise. The U.S. dollar’s recent decline does not look like that of a bear market. After the U.S. dollar peaked in 1985 and 2002, it CRASHED in a straight line. The U.S. dollar’s recent decline has been very shallow and orderly. So if the bull market is not over, the U.S. dollar will start to rise in late-May 2017.
“Oil’s decline is not over because production is surging.”
Oil might bounce from the $40 level before falling below $40. We don’t think a retest of $30 is likely. The U.S. oil rig count continues to rise despite falling oil prices. The rig count is a lagging indicator for oil.

Global economy
“The global ex-U.S. economy will slow down because China’s economy will slow down into year-end.”
After a significant improvement in 2016 and early-2017, China’s economic data has deteriorated a little in the last 3 months. This is because China’s president is too busy making political maneuvers to boost the economy. His political plays will end when he consolidates power at the Communist Party’s meeting in October. After that, China will implement a big fiscal stimulus package in December 2017.
Where have we seen this story before? A soaring U.S. dollar, falling oil prices, and a slowing global economy? This was the leadup to 2015 and 2016’s big correction!

Bottom line – what we think will happen to the U.S. stock market

Our model says that this is still a rally in a bull market.

  1. We agree that this is still a bull market. There are no bear market signs.
  2. However, we think that a small correction will probably begin right now.

We’ll buy when the S&P finishes its small correction (probably when it falls 6-7%). This will probably happen in July-August 2017. Then the S&P will rise again.
But if the global asset situation (oil, ex-U.S. currencies, Chinese economic growth) continues to deteriorate after the S&P’s initial bounce, then prepare for a big correction. This might be the big correction that our model fails to predict.
*if we buy UPRO after the S&P falls 7%, we will profit 20-25% by the time the S&P makes a new high!

4 comments add yours

  1. You and several others in the DGI/investing community have been selling some or all of their positions for the last seven or eight months in anticipation of a correction. I totally understand your rationale for being able to “sit on the sidelines” as your portfolio has already performed quite well in less than half of 2017. So why not take the chips off the table as, in essence, your 2017 goal has been pretty much met. I still plan on staying the course and holding all my stocks as I am more focused on the passive income flowing regardless of stock price movements. Thanks for sharing.

    • Right. The optimal course of action is actually to remain fully invested (according to our model). But in order to reduce short-medium term risk, we’re shifting to cash.

  2. Do you use a stop loss when you buy UPRO and if so where do you like to place it? Is your model proprietary, or do you have it published somewhere? Thanks.

    • We do have a stop loss, but it’s determined by a combination if technicals (price) and fundamentals. The model is proprietary.

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