The 60-40 Correction
Traders have been tearing their hair out this year, if they have any left.
The indecisive, flip flopping, ?RISK ON?/?RISK OFF? state of play has been devoid of any direction clues for the past three months. Gold (GLD), the yen (FXY), and bonds (TLT) have been even worse, flat lining inside of narrow ranges.
Hedge fund P & L?s have been hemorrhaging everywhere. The brokers are doing not much better, with some big ones reporting profits down by 50% or more. For many, it is shaping up to be the worst year of the decade.
I have to confess that I have not seen conditions like this during my own long and varied career. I can make money in up markets, and in down markets. But I am helpless in that go nowhere, with option implied volatilities at all time lows.
Better to go take a long nap.
Bulls hate the market because it won?t go up, and bears despise it because it fails to fall. So, what gives?
A page out of the Investing 101 handbook might explain everything.
For eons now, possibly for entire epochs, investment advisors have recommended that their clients place 60% of their liquid assets in stocks, and the remaining 40% in bonds. When extreme market moves knock portfolios out of this cherished balance, they should buy and sell securities to bring it back in line.
And therein lies the problem.
2013 delivered one of the most spectacular stock performances in history, with the S&P 500 up 26%, and 29% when you include dividends. Bonds fell, the (TLT) plunging from $114 to $101, taking the ten-year Treasury yield up from 1.80% to 3.02%. Those who started last year with a traditional belt and suspenders 60%-40% balance ended up 2013 with a portfolio closer to 70%-30%.
So what have investors been doing since the beginning of 2014? Selling stocks and buying bonds to return their desired 60%-40% balance.
This all sounds nice in theory. How much money are we talking about to achieve this rebalancing? A lot. A whole lot. I?d say about $600 billion.
The markets certainly believe in this theory. Bonds have been the most ardent followers, going up since the first trading day of the year. It has posted this blowout return despite the Fed throttling back its monthly bond buying by a massive $40 billion a month since the end of last year.
Stocks are more skeptical, befuddled by the random noise of earnings reports, geopolitical events, ultra low interest rates, and the residual effects of the Fed?s quantitative easing.
Selling was largely confined to the sectors that had risen the most, technology (QQQ), small caps (IWM) and biotechnology (IBB). So instead of a move down in any appreciable way, stocks have given us monotonous sideways action.
How does all this end?
Get everyone?s portfolio back to 60%-40% and the way then becomes clear to fall out of balance again. How will this be resolved? Stocks will gain and bonds will take a nosedive, until we approach the 70%-30% ratio again.
This paves the way for a blowout fourth quarter in the stock market that I have been predicting all year. That should take the (SPX) to 2,100, or up about 10% on the year. What will take the lead? Technology (QQQ), small caps (IWM), and biotechnology (IBB), the sectors that were hit the hardest earlier in the year.
This is why I started piling on risk positions last week, buying Apple (AAPL) and Google (GOOGL), and selling short Treasury bonds (TLT) and the Japanese yen (FXY).
