Better To Be Early Than Late When It Comes To Being Defensive

Over the years, I have always felt that it was better to be early to exit a long-term bull market than to wait too long and leave it too late. I never really had taken the time to test my theory and gather stats on the subject, it was just a gut feeling. Over the weekend I found myself thinking about the matter again as I was scrolling through some weekly charts.

Don’t get me wrong, I am not saying we are entering a bear market at this very moment. I just have concerns about some of the sentiment indicators and the duration of the current bullish cycle. Of course, the ongoing trade disputes have me uneasy as well. But the thing that got me to thinking about whether it was better to start shifting assets out of equities and into fixed income came from a practice that I do every week. Looking at charts—both daily and weekly charts for the major indices and the major sectors.

What I found this past weekend was that all four of the major domestic indices have seen the weekly stochastic readings make a bearish crossover in the last two weeks. The Dow did it two weeks ago and the other three (S&P, Nasdaq, Russell 2000) all did it this past week.

This discovery had me thinking about my own view when I came across a video on my LinkedIn feed. It was a brief commercial from Russell Investments titled “The Cost of Being Wrong” and it was a YouTube video. I took the liberty of taking a quick screenshot of the key information and have posted it below.

The video also asserted that the markets peak approximately six months before a recession. This assertion was a little confusing as the Dow and S&P haven’t made it back up to their peaks in January while the Russell 2000 and Nasdaq hit new highs last week.

Because of this observation, I went back and looked at the two most recent bear markets, 2000-2002 and 2007-2009, to see how the four indices behaved in those instances. In the 2000 bear market, the Nasdaq and Russell both peaked in March of that year and started falling immediately—especially the Nasdaq. The Dow and the S&P held up better and came close to matching their highs again in September of 2000.

In the bear market that started in 2007, the Russell peaked in July of that year while the other three all peaked in October.

The first scenario is more along the lines of what I would have expected to happen. I would have thought that the initial move by investors would be to shift money away from riskier assets and into more stable assets. This would lead to selling in the Nasdaq and Russell while the S&P and Dow will hold up. Then when it becomes clearer that greater action is needed, all of the indices fall as investors abandon all stocks.

So what does the current situation suggest with the Dow and S&P peaking in January and the Nasdaq and Russell peaking (so far) last week? To me it suggesting that we aren’t facing an all out bear market yet. But I do think caution is warranted and that becoming a little defensive wouldn’t be a bad thing.

Personally, I think you should apply defensive measures in stages anyway. For instance, when the sentiment was so high in January, I was recommending caution. I even wrote:

While the momentum is clearly to the upside, when we start seeing extreme bullish readings that haven’t been seen in 30 years, it makes me nervous. I wouldn’t rush out and sell all your stocks, but I would be paying closer attention to my portfolio if I were you.

Let’s say you had 60% of your assets allocated to stocks at the time. When you see extremely high sentiment readings, shift 10% to fixed income.

Then maybe you apply another shift based on technical developments such as the 10-month moving average on the S&P crossing bearishly below the 20-month moving average. Looking at the chart below, you can see how much of the decline you could have missed by applying this strategy during the last two bear markets.

I am of the opinion that the sentiment provides us with the first clue about a correction and then the technical factors. Finally, the fundamentals catch up and start showing weaker earnings and the like. I also agree with the findings from Russell Investments that it is better to be defensive too early rather than too late. If you haven’t made any changes to your portfolio this year, I would suggest doing so and doing it soon.

About Rick Pendergraft

Rick has been studying, trading, analyzing and writing about the investment markets for over 30 years. He has worked for some of the largest financial publishers in the world and he has been quoted in the Wall Street Journal, USA Today, the New York Times and the Washington Post. In addition, he has been interviewed on Bloomberg, CNBC and Fox Business News. Rick’s analysis process includes fundamental, sentiment and technical analysis. Rick started college as an education major, wanting to teach economics, but eventually changed to majoring in Economics and received a Bachelor of Science in Economics from Wright State University. His desire to inform and educate people is at the heart of his writing.

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