Season Investments

facebook-logo.pngtwitter.pnglinkedin-logo.png

Is Cash Really Trash?

Posted on November 27, 2018

“If you can’t take a small loss, sooner or later you will take the mother of all losses.” – Ed Seykota, trader

2018-11-27_trash.jpgAfter multiple years of a steady grind higher, 2018 has ushered in a fresh wave of volatility for the global stock market. In early January we profiled the historically low levels of implied and realized volatility in our Insight entitled Slowmentum. Last year marked one of the lowest levels of realized volatility on record. During those low volatility, upward trending in the markets, the old investment adage of “cash is trash” definitely holds true. But since that time, the waters have become quite choppy, and the various measures we referenced in that post have all spiked. As the chart below shows, 12-month volatility has climbed back to a more historically normal level near its long-term average (as measured by annualized standard deviation). 

2018-11-27_rlzd_vol.png

The wild swings in the market are understandably making more and more investors nervous, and it’s not surprising that we are starting to have clients ask us about whether or not MarketVANE is prompting us to reduce our exposure to stocks. For review, MarketVANE is our proprietary trend following model that uses basic math to measure the direction and strength of the overall trend in the market. You can think of it like a weather vane for the stock market.

Rather than trying to predict the future, MarketVANE simply identifies what is currently happening and tries to get in line with it. In doing so it looks at what we consider “intermediate term” trends over a roughly six to nine month window, so it’s relatively long-term and won’t produce trading signals for every small up and down in the market. Consequently, sell signals will never be perfectly timed at the top and buy signals will never be perfectly timed at the bottom.

Given the volatility that we’ve experienced this year it’s natural to expect we may have begun trimming exposure to stocks and holding some cash - and that’s exactly what’s happened. The chart below shows the cash targets inside MarketVANE STOCKS over the past ten years. As you can see, the model’s back test reflects an all cash signal in the midst of the financial crisis, and then again temporarily in 2011 amidst the European crisis and downgrade of the United States’ credit rating. Other than that, the model has called for holding a slug of cash on just a handful of other occasions and for relatively short periods of time.

We are now in another one of those periods. At the end of October the model went to 20% cash, and then 40% cash just two weeks later.

2018-11-27_mv_cash.pngTo put these cash signals into the context of what the market has been doing, the below chart reflects the price action of the global index since the beginning of 2017. As you can see, 2017 was a smooth, steady climb upward, but 2018 has been an entirely different story. On an intermediate term basis, the trend is now broken down to the point that our overall exposure to stocks has been nearly cut in half inside the model.

2018-11-27_acwi.png

One point of clarification is that rather than monitoring the trend of the overall global index, MarketVANE STOCKS actually does so for sixteen underlying components. It then allocates to the top five components in equal 20% parts. As those individual components begin breaking down they are removed from consideration in the portfolio, and if fewer than five of the overall sixteen are eligible to buy the extra slots are simply held in cash until a recovery ensues. At the present time, the only three components giving us buy signals are Consumer Staples, Utilities and Health Care. As such, we have 60% invested evenly across those three sectors and 40% in cash. It’s also interesting to note that these three sectors are some of the most defensive, meaning even our remaining equity holdings are on the very conservative end of the spectrum.

Where we go from here obviously remains to be seen. If we are in the early innings of a longer-term downturn our current positioning and cash holdings will prove to be well-timed. However, if the market stabilizes and resumes its uptrend we will incur an opportunity cost until we get back to fully invested. We summarize this dynamic in a previous post, The Babe Ruth Effect:

There is no such thing as a perfect investment strategy, and one of the clear drawbacks of the type of trend following model we’ve built in MarketVANE is the number of times our signals will be wrong. Sometimes the market begins breaking down and a sell signal is triggered just in time to miss out on the rebound. Or vice versa, sometimes a brief rebound within a longer-term bear market will trigger a buy signal only to watch the market roll back over and resume its downtrend. We call these signals “head fakes” because the market action begins moving a certain direction but does not continue doing so. Not only are these types of wrong signals possible, they actually happen more often than not. MarketVANE, in other words, has a low batting average.

As we explain in that post, we believe the lost opportunity resulting from these head fake signals will be more than made up for if/when MarketVANE successfully preserves value in the prolonged bear markets. That is why we say that MarketVANE (and most trend following disciplines for that matter) have a “low batting average” but a high “slugging percentage.” For more on that point, we encourage everyone to go back and read our previous Insight in its entirety.

Cash signals are a funny thing...inevitably we feel a bit of apprehension every time we get them. It can be difficult to follow the process knowing that there is a decent chance the market could stabilize and begin recovering from these levels. That said, if there’s one thing that we’ve acknowledged ad nauseam on this blog it’s the fact that we don’t have a crystal ball. This makes it incredibly important to remain disciplined in following a defined process, especially during times like these when volatility may be stirring up an emotional response. If the market rebounds from here it won’t be long before we’re back to fully invested, but for the time being we’re perfectly content maintaining a defensive posture in case there is more pain to come. For those of us that follow a trend following discipline, cash isn’t always trash!


david_headshot_bw.jpgAuthor David Houle, CFA is a founding member of Season Investments. He serves as the firm's Chief Compliance Officer as well as sitting on the investment committee overseeing the management of client assets. David spent nearly ten years in various roles primarily managing individual client assets prior to co-founding Season Investments. David graduated with a degree in Finance from Colorado University in Colorado Springs in 2003 and earned the Chartered Financial Analyst (CFA) designation in 2006. David and his wife Mandy have three children and spend most of their free time with friends and family.


Subscribe to our Weekly Insight via email!

 


Transparency is one of the defining characteristics of our firm. As such, it is our goal to communicate with our clients frequently and in a straightforward way about what we are doing in their portfolios and why. This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities. It represents only the opinions of Season Investments. Any views expressed are provided for informational purposes only and should not be construed as an offer, an endorsement, or inducement to invest.