A Yo-Yo Trick to Master Right Now

John-DV-150x1502016 might be the year of the Yo-Yo market. Up, down, up, down, up, down. It’s enough to make your head spin. And in true Yo-Yo fashion, it likely has a few tricks up its sleeve as well.

The biggest trick will be to pick your pocket!

After a nosedive, investors become too bearish and so the market rallies again. Then they’ll jump on the bandwagon and buy stocks just in time for the rally to fizzle out.

Out too early. In too late.

Given extremes in sentiment and weak demand indicators, we may be back at the point of turning down again…

As you well know, 2016 started off with a huge sell-off. While investors likely didn’t slash their wrists and jump out windows, it was the worst start to a year ever.

Then stocks turned on a dime to finish the first quarter with a lot of strength.

After a few short weeks, we’re now collectively too bullish again. Professional investors, individual investors, speculators… they’re all too optimistic about stock prices.

Actually, professional investors are among the worst when it comes to allocating to stocks at opportune times. As the market was getting smashed in the first quarter, their equity allocation dropped down to about 20% at the exact low. Now it’s up near 80% after a huge rally.

Historically, this level of stock allocation has led to 0.1% annualized returns. Lots of risk for very little reward.

Individual investors have fared a little bit better. They only upped their stock allocations by about 3% recently, with that coming out of their cash position. Currently, at 65%, the stock allocation is below what it was at the last two major tops, but only by 5%.

One of the best composite indicators is the Ned Davis Research Crowd Sentiment Poll. Currently it stands at 66.6%, which is overly optimistic. Historically, this has yielded annualized returns of just 1.9%. So again, a lot of risk for not much return. Earlier this year, sentiment bottomed at 42.8, which coincided with the market bottom.

My point is: we’ve come too far, too fast. The easy money has been made.

It’s time for this Yo-Yo to head back down and the signs are there that it’s started.

Analyzing speculators is a great way to uncover shifts in the market before they become obvious. In the past week, levered inverse funds saw their inflows increase by less than 1%. This was the lowest level since mid-February, when the market bottomed.

Investors in levered funds are just one notch below gamblers. They piled into this trade at the bottom and burned themselves bad. They’re now pulling back on trading levered inverse funds.

As these speculators cut back on their shorts recently, they increased bets into levered long funds. These funds saw an inflow of 0.3% of assets, which was the first increase since January.

So here’s a Yo-Yo trick to implement right now: do the opposite of what the masses are doing! It almost always pays.

Besides looking at individual and professional investors, analyzing what corporations are doing is also enlightening. Stock buybacks are still occurring. As I’ve discussed before, they’re a major driver of the market performance over the last seven years. But, this year they’re down over one third from a year ago.

As buybacks trail off, not only does that impact the demand for stocks in a negative way but it also could impact earnings. Companies have used buybacks to prop up earnings per share in the face of weakening revenue and maxed out profit margins.

This could be a set-up for earnings disappointments as 2016 wears on. Muted earnings and excessive optimism mean that the downside is much more significant than investors realize today.

Be on the lookout!

Don’t let the Yo-Yo knock your feet out from under you on its way down.

John_Sig

John Del Vecchio

Editor, Forensic Investor

 

 

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Categories: Investing

About Author

In 2007, John Del Vecchio managed a short only portfolio for Ranger Alternatives, L.P. which was later converted into the AdvisorShares Ranger Equity Bear ETF in 2011. Mr. Del Vecchio also launched an earnings quality index used for the Forensic Accounting ETF. He is the co-author of What's Behind the Numbers? A Guide to Exposing Financial Chicanery and Avoiding Huge Losses in Your Portfolio. Previously, he worked for renowned forensic accountant Dr. Howard Schilit, as well as short seller David Tice.