For all of those fans of The Walking Dead out there, you know what it means when I say, “there can be safety in the herd.” One thing that’s always annoyed me about that show was they explored using the herds for cover in Season 1 and then didn’t do it again until Season 5. The zombie apocalypse has come to Georgia and why expose yourself to unnecessary risk and drawing down your ammunition when you can simply smear yourself with walker blood and blend into the herd? Yeah, you may have to hold your nose so the smell doesn’t offend you, but why pick a fight you know you can’t win? A week like this one reminds you why that most basic of zombie survival principles can be equally applied to the world of investing (and who says you can’t learn anything by watching television all day?)
For those people who decided not to waste their lives in front of the TV, the more scientific description of investor herding has to do with behavioral finance. Rather than my explaining it, let’s have Jeremy Grantham (via Pragmatic Capitalism) explain it for us:
“The central truth of the investment business is that investment behavior is driven by career risk. In the professional investment business we are all agents, managing other peoples’ money. The prime directive, as Keynes knew so well, is ﬁrst and last to keep your job. To do this, he explained that you must never, ever be wrong on your own. To prevent this calamity, professional investors pay ruthless attention to what other investors in general are doing. The great majority “go with the ﬂow,” either completely or partially. This creates herding, or momentum, which drives prices far above or far below fair price. There are many other inefﬁciencies in market pricing, but this is by far the largest. It explains the discrepancy between a remarkably volatile stock market and a remarkably stable GDP growth, together with an equally stable growth in “fair value” for the stock market.”
You can see this going with the flow trend simply by observing price behavior, which was supposedly random, can have some informative value (or else technical analysis really is worthless.) Investors tend to stampede out of one asset when prices begin to weaken, moving entirely to another (often buying high and then selling low) all the while keeping an eye on their competitors to see what the next shift will be. After hitting an extreme level, the move will begin reversing itself with a few intrepid traders leading the way while the rest of the herd waits for confirmation.
Let’s use the classic example of the S&P 500 ETF (SPY) and iShares 20+ Treasury ETF (TLT). The somewhat routine sell-off that began on September 8th was exacerbated by the volatility in the energy sector and leading to a major cascading sell-off as hedge funds were forced to liquidate. At the same time, TLT shot up higher as buyers moved to “traditional” safe-havens investments for protection (even though you can suffer a capital loss.) The trend reversed at mid-month following massive sell-volume on SPY and corresponding buy-volume for TLT. With SPY, you saw it on the 15th when the close was above the open and dramatically higher than the low of the day on heavy volume while the situation was nearly reversed for TLT. At that point, both were reaching extreme levels relative to their price history leading a few investors to decide it was a washout and there was now low risk in buying equities or selling Treasuries. Sometimes it pays to go with the herd while other times it’s better to fight the trend.
To demonstrate on going with the herd, last Sunday, I wrote that the most likely course for the S&P 500 this week was a drift higher to perhaps 1980 or 1990 where we could see momentum stall out as we approached the old highs. We’re going to give ourselves partial credit; we told you not to fight the trend and to keep an eye on your profits, but boy did we miss out on how much life was left in equities. But hey, who could’ve predicted the Japanese would go full monetization on us with the expansion of their QE program being enough to take down the entire anticipated Treasury issuance! Hopefully Abe won’t let this opportunity go to waste and can expand the budget deficit to go full Keynesian on deflation’s a$#. With both monetary and fiscal policy working towards the same goal, Japan might finally begin limping its way out of the lost decade.
Here at home, the Japanese QE announcement was just the icing on the proverbial cake as better-than-expected economic announcements regarding 3Q GDP, Chicago PMI, and sentiment cushioned the blow from a slightly hawkish tilting FOMC press release as well as weaker durable goods orders, personal income and income growth. But as you can see from the charts below, the bulls have been in charge.
Equity Technical Review:
First let’s look at SPY where Wednesday has been the only day where the selling pressure was strong enough to have a close below the open and while the volume has been decidedly lighter it has been nearly one way:
In fact, look at the monthly chart; you can see that after hitting the 20 month moving average, we’ve recovered all of the drawdown and hit a new high while taking the pressure off and reversing the prospect of a 2/10 crossover signal indicating it was time to go short. We haven’t seen a spread between the monthly high and low this wide in a LONG time:
Moving over to IWM, we’ve just about recovered 100% of the drawdown from the September-October pullback, pushed out of its downtrend line and back into the consolidation zone it has been stuck in for nearly all of 2014. There’s a strong possibility of a close below the open today signaling selling pressure, but we can evaluate that more on Sunday.
In fact, it’s been such a risk-on, one-way trade that even the energy sector where the earnings expectations have been slashed and a rising dollar is guaranteeing more pain is having a decent day. Yinzer Analyst momentum scores have been incredibly strong; in fact the S&P 500 and IWM short-term scores are at the 1st percentile while longer-term momentum scores are still somewhat depressed. If it wasn’t for the Japanese announcement, the most likely direction for domestic equities today would have been a slight drift upwards as buyers who sold out near the bottom continue to rebuild positions, which brings me to one of my favorite market timing tools and a good example of when to fight the trend, Good Harbor.
Good Harbor Tactical Core:
You may remember that in August we discussed using the Good Harbor Tactical Core Fund (GHUAX) as a timing tool because to quote an adviser I know, “they’ve been perfect in 2014…they managed to buy at every top and sell at every bottom.” Good Harbor’s strategy is built around momentum, buying with the herd and leveraging their positions to enhance returns…which works well during periods like 2013 but the volatility and back-and-forth nature of 2014 has made them dead-last among tactical equity funds for the year. With the option to trade either at the start of the month or mid-month, Good Harbor has managed to pick entry/exit points that have neatly coincided with turning points in the market cycle. Sometimes, it doesn’t pay to stick with the pack.
In August we showed you this chart of UWM, one of GHUAX’s preferred vehicles for adding mid-cap exposure and typically pared up with IWM:
And here’s the follow-up:
You can see that GHUAX added exposure again at the start of September, took it off at the end of the month and then choose to sit out for their mid-month rebalancing, leaving their positions mostly in intermediate bond ETF’s and possibly one smaller position in IVV (volume spikes around mid-October make it difficult to trace.) In terms of performance, they managed to capture nearly all of September’s downside while missing all of the upside with the fund down 9.44% since September 1st through yesterday while the S&P 500 is now off .44%.
Why do I bring this up now…because it’s the end of the month and time for Good Harbor to reallocate their portfolio’s and for some of us, time to figure out which way the wind is blowing? GHUAX is a good example of when it might be more advisable to go against the trend. What do you think Good Harbor’s volatility and return this year would have been if they had simply stuck to a 60/40 blend using SPY and AGG? About 7.8% before fees, and while it would have trailed the S&P 500, GHUAX would probably have a much lower volatility and giving a higher Sharpe ratio making it an easy sell.
At the end of the day, whether you’re going to go with the herd or fight it is entirely up to you…success depends on timing and perspective. Fighting the herd and going short (which we advised you not to do until we had the 2/10 crossover) would have just led to more losses, but going with the herd can also bring more pain in the short-term. The key is to remember your goal and your time frame and then to turn off the news and focus on what’s really important; like dressing up your dogs for Halloween.