Weekly Note - June 30, 2021 - Increasing Box #2 Cash

This post covers:
  • Why we increased Box #2 Cash this week
  • Why increasing cash was done outside of our regular Friday trading schedule
  • Why I selected 70%
  • The magnitude of the potential decline
  • Factors that might affect the magnitude of decline
  • How this event affects a longer-term market outlook

Why we increased Box #2 Cash this week…

I gave guidance this week to increase Box #2 Cash because of a shift in one of the Market Resilience Indexes for the DJIA. The event that caused this change is that the Exceptional Macro MRI ended and ceased to provide resilience last week. This and other market conditions fit the criteria I established for signaling that we should increase the amount of cash in our accounts outside the regular Friday trading schedule.

The Exceptional Macro provides resilience infrequently. Over most periods it is absent. It is designed to appear at the beginning of a strong market rally, which typically occurs just after a major market decline. The appearance of the Exceptional Macro MRI indicates that the Macro MRI is likely to shift to a more positive trend. In many cases, this marks the beginning of a strong and long-lasting period of high returns that last roughly a year for the DJIA. Our algorithms are designed to shift money into the stock market when the Exceptional Macro begins.

After about a year, however, the Exceptional Macro ends and the market often makes an abrupt but brief decline. It is this dip that we hope to avoid at this time.

Why done outside of regular Friday trading schedule…

The end of the Exceptional Macro has been a very good signal for near-term price declines over the last 100 years, but its key drawback is that we must respond to it quickly. Historically, if we wait to trade the following Friday, the losses are not avoided in many cases. Thus, we need to trade early in the week – earlier than Friday - to benefit from this signal.

The historical simulations that I show do not reflect acting on this signal. The performance of the algorithms is strong without responding to this signal. But for those with short time horizons (say, less than 7 years) responding to these circumstances can reduce losses and increase returns.

Another point that favors responding to the signal is that small declines can increase investor anxiety. Anxious investors tend to sell and selling pressure can lead to further declines. Thus, avoiding smaller losses can help us avoid potentially larger losses.

Why I selected 70%...

I suggested increasing Box #2 Cash by an additional 70 percentage points. The 70% is a large move and I decided to make a large move out of the stock market early and move gradually back in the market on our Friday trading schedule, as appropriate.

An alternative to this approach would be to reduce our allocation to stocks more gradually, say, increasing Box #2 Cash by 20% each week. This approach is suited to when there is ambiguity about the signal and the declines are not abrupt, neither of which is not the case in this situation. The signal is clear and the declines associated with these conditions are typically abrupt - taking place over a few weeks. After the decline, the stock market is likely to resume an upward trend, all else equal.

We could start moving back into the market on our regular Friday schedule as early as next week.

The magnitude of the potential decline…

The end of the Exceptional Macro MRI alone could precipitate a decline of about 15%. I mention below other factors that might lead to deeper and shallower declines.

From a purely resilience perspective, the situation as it stands today is not commonly associated with the biggest stock market declines (those down more than 20%). The stock market decline of 2011 is the most recent good example of how quickly the declines can occur.

In 2011, there was a decline of about 15% from July 1 through early August. The recovery began at the end of September. The time of year is similar to today but I see the situations as different and do not look to 2011 as an exact model for how the current situation will play out.

The key point of 2011 is that the decline was sharp – most of the decline took place in about a month – and was big enough to try to avoid. Based on dozens of similar situations over 100 years, my expectation is that the decline, if it occurs, will be abrupt.

Factors that may affect the magnitude of decline…

A factor that may result in a deep decline is currently high stock valuations in the context of rising interest rates. High current stock prices compared to corporate earnings and the book value of company assets may be justified by historically low interest rates. Yet, interest rates are likely to experience more upward pressure over the next few weeks (based on the MRI readings for the US 10-year Treasury bond index). As interest rates rise, the high valuations of stocks may be less justified.

Factors that may result in a shallow decline are, first, ample government stimulus underway contributing to strong post-pandemic economic growth. Since April of 2020 the stock markets have been supported by the expectation of stimulus and high post-pandemic growth. Strong economic growth could more than compensate for higher interest rates, which are likely to remain low by historical norms.

Second, the Micro MRI, indicating the shortest cycle of resilience I typically discuss, is toward the lower end of its normal cycle. As of last week, it was at the 24th percentile of levels since 1918. While it is still in the downleg of its cycle, it may move to the upleg of its cycle in a few weeks.

How this event affects a longer-term market outlook...

Over the last 100 years, the stock market often continues an upward trend after experiencing the abrupt decline associated with this signal. It a few cases, the market has begun a more negative trend. Both paths are reliably managed by the algorithms. Thus, by itself, this event has little bearing on a long-term outlook for the market.