The Fed and the Mindset for a Downturn

I can hear it now from someone reading the title:  ‘A HA!  this guy is finally bearish after all this time — I knew he would come around‘.  That couldn’t be further from the truth, in fact the bearish label is completely inaccurate.  I don’t like labels, as when we describe ourselves bullish or bearish that puts us in a specific mindset unable to be flexible.  Hence, when we change our minds and decisions with changing markets our tactics are questioned.  In other words, don’t put me in a box.

Markets move in cycles and if we’re not able to identify shifts in these cycles, money flows and pricing structures then we will just be making the same mistakes in prior periods.  There are many valid arguments for bull market runs but also many good arguments for bear raids.  Liquidity and Fed accommodation are at the top of the list, and as long as those are strong you can bet that any pullback/correction will be short-lived.

Will there ever be a bear market?  Absolutely, and probably will cycle out the same as prior ones in terms of time and price (but unlike 2008/09 for specific reasons).  History tells us most miss a bear market, because they are far to late in identifying the conditions, preferring to continuously buy dips, fight a new trend that is swift, painful and over before you ever had a chance.  But if you’re unable to see what is truly happening and be flexible, you’ll get hit.  It’s like they said the five things to remember in the movie Dodgeball:  dodge, dip, duck, dive and dodge.

The Federal Reserve has been highly accommodative for more than six years and frankly has no plans to remove the easy monetary policy.  Oh, we are hearing about rate hike coming, likely to come on the back-end of 2015, but don’t be fooled – this rate hike cycle will be slower than molasses pouring out of a bottle, and may bore the market to tears.  A rate hike cycle is likely to change asset allocation models, and if there is any hint tighter money is going to retard economic growth then cash will soon be the big asset class (nobody will be buying stocks or bonds).  However, we are far away from that point, and even with low-interest rates we must acknowledge the Fed is still highly accommodative.

So many players wanted to grab a piece of that 2008/09 downside that they now will do whatever it takes to be part of the next slide down.  For those who lost money during that time it was a vow to not let that happen again.  Market moves change behavior and psychology.  However, it’s not that easy trying to time that move, in fact you have to be willing to wrong so many times before finally getting it right.  If your motive is to predict rather than react to situations/conditions then you’ll eventually get it right – but you may be wrong 20 times before you finally get it right – and how far behind will you be before you actually do make the right call?  Further, would your followers have already flamed out waiting for your prediction to come true?

The Fed has not given up on the markets nor the economy but are clearly annoyed at not being able to normalize policy.  They always have one eye on the stock market and the short-term disturbances that could detach the positive psychological vibe instilled over the last few years.  But how does one prepare to play the downside?  It’s a rhetorical question – one to ponder but not to be answered.  History shows us markets have a bias to the upside and if we believe in riding markets down to unknown depths such as in the financial crisis then we’ll become too complacent and eventually get swallowed up by some huge upward swing.

It seems the best course of action might be to buy some portfolio protection for the short-term to insure against quick moves against the market moving lower.  With a VIX around 12% currently that means option premiums are inexpensive and putting on that protection has not been cheaper.

Instead, understand the conditions and environment of the market.  The economy is stuck in a low growth trend that seems the be harming some companies’ growth plan but is not hurting others.  Hence, there is no reason to believe the stock market is coming unglued, but the charts/technicals will provide us with some great clues to play stocks to the downside.  One tool I prefer to use is the Chaikin Analytics, which for example showed and extremely bearish reading across all indicators last week prior to earnings, and then the stock plunged more than 20% in a single session.  No bias, no subjectivity, no hope — just the facts as presented where if you prepared yourself for the opportunity you had a huge winner.