Diary of a Financier

The gameplan: Fade the pullbacks & accumulate risk until this summer

In Capital Markets on Wed 10 Apr 2013 at 22:45

We got the short term pullback I had expected in my last technical appraisal of SPX (-1.9% from publication to trough), and I was able to add a bit to my risk assets–among them the Russell 2000 Small Cap ETF (IWM), which had overshot the downside. The 2006 SPX analogue, my guide to the market, is still tracking tightly, so I wanted to update my technical outlook.

In the short term, there’s some meat left on this bone–even after today’s +1.22% close. Per 2006’s example, SPY should be able to eek out another +1.5% over 11 days (ending circa mid-April to the 25th at latest) before meeting a sharp -2.25% pullback over only 3 days:

SPY 2006 v 13 daily

SPY 2006 v 13 daily

I cannot emphasize this enough: the intermediate term should be my focus. Hence, the following weekly chart is what’s hanging on my wall right now as a reminder. I’m going to continue deploying cash and reallocating into assets that’re levered to risk, but any down days should be used to accelerate that relevering process, because the trend is higher until this summer. The weekly charts show me that SPY has another +3.6% upside over the next 11 weeks (ending circa July 1), at which time the material 2013 correction should strike, with a -7.9% drawdown across 6 weeks:

SPY 2006 v 13 weekly

SPY 2006 v 13 weekly

Why would I be adding exposure for such little return (3.6% upside) vs. so much risk (7.9% downside)? Quantifiably, that’s just imprudent, right? Well, when I analyze the performance of the highest beta risk assets in 2006–as opposed to vanilla SPX blue chips–the risk/reward numbers are far more attractive: I expect a +7.1% rally in IWM (vs +3.6% for SPY) over the next 11 weeks, which is significant outperformance. As I observed three weeks ago:

“IWM’s near term low is in (2/25 @ $89), and Small Caps will rocket higher, outperforming for next quarter (14 weeks)… When the small cap outperformance ends around the beginning of July, it marks the top for IWM/SPY ratio, then the midsummer correction begins before exuberance sends the market to a blowoff top.”

~~~~

This year’s ephemeral pullbacks (I count 3 so far) have all been shallower than I expected. In retrospect, that makes sense, as the herd has unanimously waited (still waiting) to buy every pullback. While I’ve been correct in anticipating each dip, I’ve had to adapt to the market’s tendency toward quick reversals by buying earlier in each successive opportunity.

The future will be no exception. I intend to continue adding to risk positions, taking a new stake in the Semiconductor ETF (SOXX)¹ and redoubling IWM–the latter for which the 2006 precedent presents asymmetric upside. Over the longer term, I’ve run the analysis of blowoff tops, and I’ve concluded that–come the summer correction–I will transition the portfolio from small cap to large cap exposures, specifically the Russell 1000 Large Cap Value ETF (IWD), which will crush all comers.

I’m still operating with a barbell strategy: lots of beta counterbalanced with lots of cash. Although the portfolio’s allocation remains 52/38/10% (stocks/bonds/cash), our beta is 0.79 (vs 0.76 benchmark) and monthly sigma 1.20 (vs 0.54 benchmark), which leverage to [upside] volatility has helped reel-in the underperformance we had in Q1.

–Romeo

¹Updated 4/12: changed to “SOXX” instead of “SMH”- SOXX is more diversified w less INTC concentration (20% allocation in SMH); SOXX also has 0.92% dividend vs nil for SMH.

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