Markets Pullback | Volatility Increases
The major market indices finally started to normalize by removing some of the froth that was built up over the last few years due to the massive Federal Reserve Quantitative Easing Program. We felt this was long overdue as we have been writing about this over the past several months. We have been cautious and preparing for a -7%, -10% or -15% correction due to multiple factors within the market place that have caught our attention. Specifically, geopolitical risks, indices at record highs, FED tapering and low GDP growth.
The first chart (above) is a 7 month daily chart of the Nasdaq Index. As you can see, the Nasdaq has pulled back nearly -9% over the last 6 weeks and has taken out the 50 day moving average and also approached the 200 day moving average before rebounding over the past 4 days. Also, as we predicted earlier in the year, volatility has increased as represented by the large daily swings that the market has taken recently. The Nasdaq volatility is due to of the risker high beta nature of tech stocks but has now double bottomed, matching the first week of February’s low. We feel that the risk of another leg lower is diminished at this time and that a short term rally to 3600 and then 3700 is possible. When the market rallied to new highs the first week of March, we wrote a blog at the time that updated everyone regarding the hedge that was put on the portfolio (as indicated by the first green box). This hedge against the long equity positions involved buying the Nasdaq double down (inverse) ETF to reduce risk and portfolio exposure to that sector. After the Nasdaq corrected by roughly -7%, we removed the hedge (as indicated by the second green box) thus avoiding the sell off and protecting profits within the portfolios.
The second chart is a 7 month daily chart of the Russell Small Cap Index. Similar to the Nasdaq, the Russell pulled back nearly -10% over the last 6 weeks and has taken out the 50 day moving average but, unlike the Nasdaq, actually pierced the 200 day moving average before rebounding over the past 4 days. The Russell was the worst major index to get hit and much like the Nasdaq, this was due to of the risker, high beta nature of small cap stocks. It has also double bottomed, matching the first week of February low. We feel that the risk of another leg lower is diminished at this time and that a short term rally to 1150 and then 1200 is possible.
When this market rallied to new highs around March 3rd, we wrote that we had put a hedge on the portfolio (as indicated by the first green box) against the long positions by buying the Russell double down (inverse) ETF to reduce risk and portfolio exposure to that sector. Like the Nasdaq strategy, when the Russell corrected by roughly -7% we removed the hedge (as indicated by the second green box) thus sheltering the portfolio from the sell off and protecting our gains.
Now we find ourselves at an inflection point that could further send us higher — but not without a struggle. We are preparing a few new long positions for the portfolio (reducing cash) but we will remain cautious to see if we stall out here or continue higher. In the intermediate term, if the Fed continues to remove themselves from the market (tapering further) and the employment market continues to improve then we feel that by late third quarter we could see an explosive rally that could last for several years. However, in the short term we currently maintain a 12% cash weighting within the portfolios, with no hedge on as we look for signs to re-enter the markets and get fully invested.