Weekly Note - May 20, 2020

The DJIA is close to the peak of its Micro MRI. As of last Friday, it was at the 85th percentile of all levels since 1918. After it peaks and ceases to provide resilience, the DJIA will be “least resilient,” meaning that none of the MRI (Micro, Macro, Exceptional Macro) are in the uplegs of their cycles. For the subsequent roughly 4 to 12 weeks, the market will be very vulnerable to declines. In the absence of very good news, prices are likely to decline.

I’d like to show you a few alternative patterns for what the market may do during this period of least resilience.

Pattern A - Typical

The image below shows a typical decline (a). Soon after the Micro MRI peaks and marks the beginning of the period of least resilience, the DJIA starts to decline.

In this pattern (above), prices decline at the beginning of the period – and the initial decline can be abrupt. Then prices move lower consistently over the period. Moving out of the DJIA at the beginning of the period is the most successful strategy.

Pattern B - Flat

The second pattern (b) is when there is an abundance of good news in the market place and stock prices remain at roughly the same level over the 4 to 12 weeks. Prices move higher temporarily on any good news but the market does not hold on to those gains.

In this pattern, staying in the market or moving out does not have a big impact on returns over the period.

Pattern C - Delayed Decline

The third pattern is a delayed decline (c). Rather than a consistent decline over the period, the major decline occurs at the end of the period.

A good strategy for pattern c is to be out of the market prior to the decline. The peak of the Micro MRI at the beginning of the period is the clearest and most objective signal to get out of the market. While doing so at that time seems premature, it is the most effective strategy for this pattern. One should be patient with the defensive position while the market moves up and down without a large gain or loss prior to the larger decline at the end of the period.

Historically, patterns a and c are most common and create large losses. Pattern b is less common. The Focused 15 Investing strategy is to get out of the market on vulnerability. If pattern b prevails, we might miss some of the positive returns but in doing so we avoid the risk that what initially looks like a b pattern is actually a c pattern. Since the losses in a and c can be very large, getting out of the stock market is the more prudent course of action.

The Current Situation

In the current situation, we are clearly at a very high level in the Micro MRI and will soon begin a period of least resilience (none of the MRI in an upleg) and we are moving out of the stock market. Raising cash over the last few weeks has been a preemptive action to avoid the abrupt declines typical of pattern a.

There is good news in the marketplace that will be influencing returns. The Fed and its counterparts around the world have pledged to do whatever it takes to heal the economy and protect investors, countries are reopening, and potential game-changing cures and vaccines make the news. As for bad news, record unemployment, an emerging wave of bankruptcies, and prolonged social distancing all create a drag on the economy and stock prices.

Since we don’t try to determine the impacts of the current news and we move out of the stock market on vulnerability, we are preparing for patterns a and c. We will see after the fact if either of these patterns were relevant. If it turns out that pattern b is most relevant, we may have taken these steps simply as a precaution.

Looking Forward

At the end of the period of least resilience (at the next market bottom), the market will likely move higher dramatically regardless of the pattern during the period of least resilience. As the market passes through the market bottom, it will become more resilient and it will then be appropriate to be more aggressive.