This is the first of a two-part series on using two simple tools to help with asset allocation in a possible transition from a U.S. bull to bear stock market.
U.S. large cap stocks last week came very close to but were unable to break their previous all-time high of 2131 of just over a year ago. Since the end of quantitative easing in Oct. 2014, the S&P 500 has been stuck in a trading range of roughly 1800 to 2100 and needs to rally above 2200, 5.8 percent above Monday’s close, to “prove itself,” according to current “bond king” Jeff Gundlach of DoubleLine.
Time to pay heed to expert market warnings?
Influential voices have raised their concerns about the market recently. Large investment banks have noted increased market risk, while several famous current and former hedge fund heads are now negative on the market. George Soros evidently feels so strongly that he has started trading again. His former star manager Stan Druckenmiller has been expressing his own very negative market views for a while. Recently, Carl Icahn and Paul Singer also have voiced negative outlooks.
With no shortage of market concerns, U.K.’s Brexit vote on June 23 is the next big development, with the Fed widely expected to leave rates alone when it meets this week as the world awaits the results of the vote. With yields declining, government bonds are rallying in a “race to safety,” with the 10-year German government bond now joining Japan’s in negative territory.
Amid the global economy’s slow growth, negative S&P 500 earnings growth over the past three quarters, and high valuation of U.S. stocks, prudent investors may want to consider these market warnings.
In addition, investors may want to form their own opinion on whether the U.S. is still in a bull market. If not, then protection of your financial assets becomes the absolutely highest priority. While no one can definitively answer that question until after the fact, there are very simple price tools that can uncover clues to help size up the big picture.
This two-part article will provide you with a couple of very simple tools to try to help you do so.
U.S. stocks’ relative strength to bonds in decline
Using these price tools does not preclude a fundamental analysis of market risks, especially those that are well-grounded in historical valuation metrics, leading economic data, and event risk, such as the upcoming Brexit vote. But valuation models are not very helpful when it comes to gaining an upper hand on the timing of any impending end to the bull market. That’s because the market timing question is heavily dependent on knowing when investors psychology is going to turn, most especially their risk appetite.
In the relative strength charts we use for big picture analysis, we compare prices of major asset classes. Relative strength charts show the “opportunity cost,” one of the most basic concepts in economics, of being in one major asset class rather than another.
In earlier posts, we used relative strength charts of U.S. large-cap stocks [SPY] to all international stocks [ACWX] and to emerging market stocks [EEM] to show the very strong outperformance of SPY in the bull market that started in March 2009.
Now to help determine if the U.S. market might be transitioning from bull to bear, we use a relative strength chart comparing the strongest major equity asset class in this bull market, U.S. large-cap stocks [SPY], to investment-grade bonds [AGG], the aggregate bond index ETF. Long-term bonds are the asset class that has been used as the main diversifier in traditional 60/40 equity-to-bond ratio portfolios, to protect against bear stock markets and provide steady income.
Click on image to enlarge
Since mid-2015, the price ratio, or relative strength, of SPY to AGG has been declining as seen in the top panel, even as SPY has been going sideways for the past 18 months, as seen in the bottom panel.
Using basic chart analysis, the 40-week exponential moving average of the SPY/AGG price ratio (the red line in the top panel) is now sloping slightly down. The weekly price ratio, black line, has now made two lower lows, and perhaps soon it might make two lower highs. The long-term trend-line from the early 2009 lows, not shown but which you can see using a straight edge connecting the lows, is being tested but seems still intact.
Combining these observations, a plausible conclusion is that the market is no longer paying investors as much for the risk of being in stocks. Does this mean investors should weight bonds more heavily in their portfolio at this time? If investors do decide to switch, when to do so is a difficult call partly because everyone has varying financial situations and investor psychology.
Also, most investors are notoriously poor at making such difficult market timing decisions. So, in the second part of this article, we will describe a very simple rules-based tool for those who want to replace or supplement their own judgment on when to overweight bonds.
Will bonds work their diversification magic in this very unusual market?
Long-term bonds in a traditional 60/40 model may not be the only alternative to stocks in the next bear market. Investors are in an extremely unusual market environment with ultra-low interest rates around the world, in part driven by unprecedented central bank policies, making for a very difficult investing environment. The ten-year government bond yields only 1.65 percent in the U.S., with much lower rates in other major economies, including -0.17 percent in Japan and now also slightly negative in Germany (for more on negative rates, see Below zero: what negative interest rates mean for investors).
It is quite possible that both stocks and bonds are currently overvalued at the same time, and that their long-term returns both will be quite low. In this case, investors can consider a safer alternative, such as short-term Treasury bills [BIL] by regularly comparing their relative strengths against bonds [AGG].
Before the 2007-09 bear market, the 10-year U.S. Treasury bond yield was around 4.5 to 5 percent, so a portfolio diversified with simple, traditional 60/40 stock/bond ratio made sense, since yields could – and did – go down dramatically during the recessionary bear market, boosting bond prices.
Click image to enlarge
As a result, SPY dramatically underperformed AGG during that very bear market, as seen in the first chart above, so a switch into bonds would have been a smart move. This also proves out the conventional wisdom that diversifying with a mix of stocks and bonds is one way to deflect market risk. But today, that 10-year yield is currently only 1.65 percent, and of course they may go even lower. But this makes buy-and-hold passive investing much more risky than in previous market cycles, since you may risk losing money on both stocks and bonds.
Indeed, as Nobel winning economist Harry Markowitz said after the 2007-09 financial crisis, “There are times when portfolios should be adjusted if risks appear outside the norm — periods such as the technology bubble and recent financial crisis.” This is significant coming from the father of Modern Portfolio Theory (MPT), on which robo-advisors and the passive investing approach are based.
So you have to ask yourself, are we in one of those times where shifting some of your portfolio into safer assets and/or buying risk protection might be the prudent thing to consider. The second part of this article will show you a very simple systematic, rules-based tool to help you with that question.
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 http://www.marketwatch.com/story/heres-what-gundlach-thinks-the-sp-500-needs-to-do-to-prove-itself-2016-05-25; http://www.bloomberg.com/news/articles/2016-03-08/doubleline-s-gundlach-says-s-p-has-2-upside-with-20-downside; http://www.reuters.com/article/us-funds-doubleline-gundlach-idUSKCN0YF2S8;
 http://www.bloomberg.com/news/articles/2016-05-10/bank-of-america-strategist-warns-of-imminent-vortex-of-negative-headlines-sending-u-s-stocks-plummeting; http://www.bloomberg.com/news/articles/2016-05-18/goldman-sachs-downgrades-global-equities-recommends-cash
 http://www.wsj.com/articles/a-bearish-george-soros-is-trading-again-1465429163; http://www.bloomberg.com/news/articles/2016-06-09/soros-returns-to-trading-worried-about-world-economy-wsj-says; http://www.barrons.com/articles/if-the-markets-crash-then-carl-icahn-could-win-big-1462828022; http://fortune.com/2016/05/10/carl-icahn-crash-stock/; http://www.businessinsider.com/druckenmiller-thinks-fed-is-setting-world-up-for-disaster-2016-5; http://www.institutionalinvestor.com/article/3556677/asset-management-hedge-funds-and-alternatives/billionaire-paul-singer-accuses-central-banks-of-thwarting-growth.html#/.V16InPnyvIU;