Diary of a Financier

2013’s equity correction on the horizon

In Capital Markets, Trading Desk on Tue 28 May 2013 at 22:26

I’d been traveling and out of pocket for a couple weeks, so now that I’m back, I thought an update to my broad market technical analysis was overdue. Just before I left, I swerved a bit and began evaluating the notion that $SPX has progressed further along this cyclical bull than I had previously considered. One way or another, the trend led higher, so I didn’t have to commit to either premise. Now, however, the threat of a proximate correction has forced expediency, and my subsequent analysis has helped me affirm the SPX 2007 analogue, which had originally emerged as a null hypothesis to my comparison du jour.

Starting at the top, an isolated analysis of SPY’s daily chart yields a pretty constructive recommendation. After March’s breakout from SPY’s long term bull channel, the technicals say we have more time before indicators or the priceaction pattern develop anything reminiscent of a top. In fact, the short term pattern is characteristic of an early bull flag:

SPY daily

SPY daily

Aligning today’s market with the 2007 daily analogue, I find that after 7 more trading days of floating higher, I can expect a SPY breakdown out of a rising wedge to prompt an 11.25% correction over 3 weeks:

SPY 2007 v 13 analogue (daily)

SPY 2007 v 13 analogue (daily)

Over the intermediate term, SPY rallied 6% over 4 months inclusive of the near term correction, from which low the rally added 13% before the next garden-variety drawdown. Per the analogue, a subsequent, major top to this cyclical bull still lies around 5½ months or +7% beyond today’s SPY (+14% from the coming low):

SPY 2007 v 13 analogue (weekly)

SPY 2007 v 13 analogue (weekly)

Thus, I’m preparing my plan for a near term correction–2013’s biggest drawdown–commencing next week. I must admit that I’m having trouble trusting this analogue because of inconsistencies. First, the daily indicators aren’t neatly aligned. Second, I don’t like the argument between the daily chart in isolation (bullish) and the precedent of the analogue (bearish). Remember that an underwhelming rounded-top dud led to this correction in 2007. The analogue would terminally fail if we got a classic breakout from that daily bull flag or continued development into a pennant. I am, of course, remaining cognizant of the remarkable momentum that lies on the other side of all this.

~~~~

From a portfolio management perspective, I added exposures today, buying ~4% stake in the Mid Cap Growth ETF ($IWP), which should be the top style henceforth, now that I’ve recalibrated to the 2007 analogue.¹ As it stands today, my plan is to unload a few tactical positions next week, at the precipice of that correction. IWP will remain in the portfolio, since I expect peerless outperformance, but sensitive holdings like $IWM, $SDY, and $SOXX will get purged in favor of cash (and buying the dip), because they’re frankly the wrong place to be during a blowoff top. I know that’s surprising–particularly for the high beta Small Caps and Semiconductors–but history says they actually do not offer sustainable alpha in the coming months/quarters. I might also halve my position in $WY by taking some gains–maybe for redeployment at a lower entry point.

Our portfolio’s beta has cranked up to 0.91 vs 0.76 benchmark, sigma 1.34 vs 0.63 benchmark, and an allocation of 64/32/4% (stocks/bonds/cash). Just the liquidations mentioned above would drop me to benchmark-weight beta. Because the inconsistencies discussed herein, I plan on being reactionary once the portfolio’s reached benchmark-weight. If the chart pattern & indicators deteriorate in neat cooperation, I’ll be looking for other fat to cut in an effort to build excess cash for shelter and BTFD. Given my fear of a material correction of this magnitude, my less-than-inflammatory initial approach stems from the argument among factors, which I’ll discuss in a Bull v. Bear edition later this week.

There are certain things we know for sure–things we can control. There are other things–like this threat–that we can only manage. I find that the prudent risk management scheme over the course of the following 5-7 days is to shed excess exposures and descend to market-weight.

–Romeo

¹I think a mea culpa is in order, as I’ll retract the entire analysis regarding “Growth underperforming value & no reversal in sight” (2013.04.24), which was largely conditional upon the retired SPX 2006 analogue.

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