We are writing this article to more fully flesh out our comments on CNBC on Friday (1/21/22) and subsequent questions that we received.
Human beings are wired terribly for investing. The tendency is to buy at highs given greed and to sell at lows given fear. Last week had the largest weekly drop in the S&P in nearly 2 years. We covered essentially all of our shorts by the end of the week. This is despite having more shorts than longs earlier in the month given our belief in a 20% correction in the S&P. We also invested 15% of the assets in the fund on Friday and used available cash in the fund to do it. However, we still have a large cash position remaining. Remember that cash was one of our Top 5 Picks coming into the year.
So why did we cover our shorts and put cash to work? We use technical tools to essentially protect ourselves from our normal human emotions and to statistically up the odds of achieving better risk adjust returns.
From their all-time record highs, the Russell 2000 is down 19% from 11/8/21 while Nasdaq is down 15% from 11/22/21 and the S&P is down 9% from 1/4/21. We used available cash sitting in the fund on Friday (1/21/22) to put 10% of the portfolio into a small cap basket & 5% into regional banks (-9% in 4 days). 31% of our 17 technical indicators were near-term oversold. We prefer this closer to 50% but some of our favorite indicators are at oversold levels. For example, the VIX (fear gauge) curve is now negative indicating investors are willing to pay more for near-term protection than longer-term protection. The selloff was also on volume that was ~60% above the 20-day average. There were more puts being bought than calls while typically ~40% more calls are bought than puts. The TRIN ratio which is the number of advancing/declining stocks (Advance Decline Ratio) divided by advancing/declining volume (Advance Decline volume) was ~1.5 versus an average of 1.1 over the past five years. This indicates a lot more urgency in the selling of stocks going down than the buying of stock going up. 51% of the S&P hit a new four week low. Despite our belief that the next 3-5% move in the S&P is higher, we believe the S&P is still ultimately down at least 20% from peak to trough due to persistently high inflation, an aggressive Fed & slower growth. (See our post on 12/28/21 for detailed reasoning.) We plan to put our shorts back on at higher levels.
Two of our larger remaining technical concerns are: 1) close to half of the worst one day crashes in history have happened on a Monday typically following a bad week ending on a bad Friday which is what just happened, and 2) the VIX closed at 29 which is below the 40 threshold we prefer to see.
Rallies within brutal bear markets are common and we hope our technical indicators help our shorts avoid the worst of these and enable us to buy longs at statistically favorable times. We have analyzed eight different bear markets but would note the statistics for the following periods which we think have similarities to the current period of time. During the Global Financial Crisis, the S&P had 11 rallies in the S&P that averaged 10% while there were 12 declines averaging 15% over nearly a year and a half. The total price decline was 57%. During the Tech bubble bursting, the S&P rallied 7 times averaging 14% while falling 8 times averaging 17% over 2 ½ years. The total price decline was 49%. And finally, over nearly two years in the early 1980s when Fed chairman Paul Volcker was fighting inflation, the S&P rallied 7 times for 8% while dropping 8 times for an average of 10%. The total price decline was 27%. This in our view is the most comparable bear market. Even during the one month 34% sell-off during covid in early 2020, there were 4 notable rallies that averaged 7%, but given 3 of them were one day moves, we do not believe they are as relevant.
In summary, we think we are close to a near-term low and wanted to reposition to take advantage of that in both our short and long positions. For those that want to stay focused on the long-term and do not have the time to manage your investments daily, we think the lows for the market still lie ahead.
Dan Niles is founder and portfolio manager for the Satori Fund, a tech-focused hedge fund.