I have to continually test my hypotheses to make sure the facts haven’t changed or the story hasn’t morphed. To wit, my recent [offline] comparitive analysis of Small Caps (IWM) vs Large Caps (IWB) brought to my attention a potential recalibration of my trusted 2006 SPY analogue. Given the full-tilt rally we’ve experienced these past two weeks, 2007 has emerged as a new analogue to guide this market forward. I wanted to record these findings, which I’ll have to vet more over the coming days/weeks.
Recall my base case expectation, in accordance with the 2006 analogue:
“+3% expected rally into July looks like a straight line headed east/northeast… before we get 2013’s real correction in the order of 7-10%… The current daily/weekly/monthly SPY charts reiterate the pronounced short term bear divergence that’s near reversal. More importantly, that haunting bear divergence in weekly & monthly charts has already been convincingly reversed–something that also happened in the 2006 analogue around this timeframe… With these longer term demons slain, the rally in risk assets can proceed towards Thrill and Euphoria.”
The following is the chart that really tripped me up, suggesting we might be further along in this cyclical bull market than I had previously thought. Notice how Small Caps started underperforming as the blowoff top hit its stride in 2007:
The underperformance appears to have persisted for longer in today’s iteration, but it got me thinking. I turned back to my SPY charts and noticed that the recent rally–steep, straight, and accelerating above all prior tops–more closely resembled that of 4q06-1q07 than any other. Plus, the daily comparison shows that after 2/5/2007, SPY continued to rally modestly for 4 weeks, with only one blip, before breaking-down out of a rising wedge and correcting 11.25% over the next 3 weeks. Indicators show a false bull reversal out of 2x bear divergence having baited a bull trap. That pattern and those indicators are developing again today:
Zooming out further to the weekly charts, I have a better view of the intermediate term. I see that in 2007 SPY rallied 6.25% over the 4 months after February 2007, despite the aforementioned 11% drawdown, from which low the rally added a full 13% before the next correction:
Were this new, 2007 analogue to prevail, that means SPY has only ~8 months and 8% upside left (from today) before its next major, cyclical top is met a la 10/2007.
I’m going to think long & hard about this conundrum, because it’s important to determine where this cyclical bull market stands in relation to another major top, especially since the low volatility air should subside (e.g. deep corrections and steep rallies should characterize the coming blowoff top, per historical precedents). The difficulty will be in coordinating all the other signals I’ve found in my multistrategy assessment; things like credit spreads, inflation expectations, sentiment/psychology, growth vs value, and long term technicals are all consistant with the 2006 analogue, so I’ll have to find other similarities between today’s environment and 2007’s before I get comfortable with the comparison. Regardless, these null hypothesis tests are a good exercise to strip my analyses of any biases I may bring to the table, keeping me honest. I’ll be back here with an answer as soon as practicable.
I have not been all that active trading the portfolio these past couple weeks. I’ve wanted to let our risk assets ride, which has proved prescient given a record string of days in the black and repeated alltime highs for major US indices. I added a bit to our $CLF long, I swapped some high yield bonds, and I raised a bit of cash by paring our floating rate bank loan exposure.¹ We’re not getting too cute with these moves, just adhering to value principles.
That said, our portfolio’s beta still hovers around 0.86 vs 0.76 benchmark, with sigma 1.36 vs 0.61 benchmark and an allocation of 60/32/8% (stocks/bonds/cash).