The market has certainly been taking investors on quite a ride lately. Investing pros sometimes (half) joke about the market taking investors on the path of maximum pain, and it certainly has felt like that at times.
After falling into correction territory last August, then re-testing those lows again in September, stocks rallied quickly to within sight of the market's all-time highs. Then came another steep decline into the New Year, and an even deeper low in early February, at which point the market appeared to be teetering on the edge of a potentially severe drop-off. That darker scenario never materialized though, and the market now sits at an inflection point roughly mid-way between last year's highs and February's lows.
I say the market sits at an inflection point because it currently is right on its 200-day moving average. That's a technically significant point, for those who follow such indicators. The market's position above or below that level is largely thought to signal whether its short-intermediate term trend is positive or negative. We've been below that 200-day moving average for virtually all of 2016 so far, indicating the market's trend has been negative. So a solid break above it would be a positive sign for a market that hasn't given a lot of those lately. That shift hasn't happened yet, but it could if the market were to rally further from here.
It's important to recognize that the stock market has already been in a "stealth" bear market for the past 18 months or so. The last of the Fed's Quantitative Easing stimulus exited the financial system in the fall of 2014, and it's easy to argue that the broader market hasn't done much since that point. Corporate earnings hit their high point at about the same time and have been lower since. And while the large-company dominated indexes kept rising slightly until the following May, a large number of smaller companies peaked in late 2014 and have been down 20% or more since then.
All of which is to say it's not totally out of the question that we've already had a bear market and could be getting ready to pull out of it. I don't personally think that's likely, given that valuations still seem high, economic risks seem to be growing rather than receding, and the large-company indexes never sold off to the point I would have expected after such a huge run higher in the bull market of 2009-2014. But we can't totally rule out the possibility.
New thinking about risk
In the years since Dynamic Asset Allocation (DAA) launched, my thinking about market ebbs and flows has shifted a little bit, to where I now think of them primarily in terms of heightening and reducing short-term risk levels. For example, when the market crashed through several "lines" of technical (chart) resistance in February, my thought process was that the short-term risk in the stock market was increasing with each breach. As the market has recovered in recent weeks, and has passed first the 50-day moving average and now is attempting to rise above the 200-day moving average, I view those steps as gradually reducing the market's short-term risk.
Importantly, these swings don't really impact the market's longer-term prospects. Nor do they change the value proposition that says you're actually getting better deals investing your regular new contributions into the market at lower price levels than at higher ones. But I've begun thinking that way largely in relation to DAA, because it's been evident how the system gradually adds and subtracts risk from our portfolio in response to these shorter-intermediate moves. As the market falls, DAA takes away our exposure to risk. As it rises back up, it gradually adds back more risk exposure. This is healthy.
It's also frustrating when the market is treading water over the better part of a year, yet swinging far enough into the range's highs and lows to move us in and out of the various asset classes multiple times. This is where the max pain idea comes in. It feels personal. It's not. It's normal.
The reason a system like DAA works over the long-term is precisely because the market doesn't typically stay in ranges like this for long. That's not to say this period has been unique — the market does go through range-bound periods like this from time to time. But these ranges resolve sooner or later, meaning they either break out to the upside or the downside. That's why we have to respect what the market is saying and respond by changing our portfolio as it drops to the bottom of the range (in case it resolves by continuing lower), only to have to switch back as it heads back to the top of the range (in case it resolves by breaking out higher). The market spends the bulk of its time moving in trends that are long enough for a system like DAA to profit from. Stretches like we've been in since August are the exception rather than the rule.
Implications for DAA
This has some implications for a strategy like DAA. On the positive side, we know from DAA's historical record that it has provided fantastic downside protection when bear markets have occurred. Less obvious is the fact that DAA provides significant peace of mind to investors — not just during bear markets, but all of the time. Knowing they're prepared for the next bear market allows members to not worry about them the rest of the time, and allows them to stay invested to a greater degree than they would otherwise be comfortable.
But these short-term shifts and the portfolio adjustments they create within DAA also present some negative implications. One that we've all experienced is the way our focus is drawn to a shorter time-frame. In the past, before DAA, it would have been much easier for us to write and you to accept a message along the lines of: "Don't worry about it — despite all the noise, the market hasn't really done anything substantial in the past six months. Sit tight and just wait for the market's trend to resolve." Now, it's much harder for some readers to not think "What has the market done since the beginning of the month when we made this change?" or "What has the market done in the past six weeks since we exited stocks?" And obviously if the answer isn't positive, that's potentially difficult for them to deal with emotionally.
That type of short-term focus can quickly breed dissatisfaction, particularly when the market is churning, as it has now for several months. The reality is that even if DAA gives up a few percentage points on each big swing back and forth, it's well worth it if at the end of the trading range we get the longer-term trend right. And the message from DAA's long-term track record is that it normally does.
It's important to recognize this is true even in cases when the resolution of the trend is higher, and a full-blown bear market never develops. That point may not be obvious at first, and our raw investment performance certainly won't show it. But if we've successfully protected against heightened risk, even if that risk didn't fully materialize, that's still valuable.
Consider this. If you had to walk across a canyon on a narrow beam, and there was a cable above the beam that you could attach a safety harness to, would you consider it to have been a waste of time to strap into the harness and clip onto the safety wire even if you never actually fell off the beam? What if you had to pay money to use the safety harness — would you consider it money wasted if you paid for it but never fell off the beam? Most people would say of course not.
The same is true with DAA. Sometimes it may "cost" us to have the protection it provides, when the market doesn't actually fall off the beam. That doesn't mean the protection was foolish to have, just because we didn't need it in a particular instance.
When annoyance becomes an actual problem
I would suggest that it's pretty normal to feel occasional frustration with a system like DAA. In fact, we told you it would happen in the very first article we wrote about the strategy back in January 2013!
If occasional annoyance is the extent of the issue, chalk it up as a cost of following DAA, remind yourself of the "insurance" or "safety harness" illustrations, and keep on.
But if dwelling on the dissatisfaction of DAA's short-term moves and performance inclines you toward either modifying or dropping the system, that becomes a serious problem. Those in that situation would likely benefit from turning over the implementation of DAA to an automated system and not being personally involved with making all the trades.
While things are looking a little brighter for the market than they did 5-6 weeks ago, we're still far from assured that the worst is over. We may get a signal to gradually start adding some risk back to DAA at the end of the month, or we may not. Keep in mind the general "topping" pattern I pointed out last week — nothing that has happened has definitively shifted us away from that general construct. It's worth noting that each of the past two bear markets had three counter-trend rallies of at least 10% within them. In other words, it's pretty normal to see bounces of the size the market has experienced lately within the confines of a full-blown bear market.
We'll keep following the signals DAA provides because nobody can know in real time whether this is a true break-out higher, or just another trip to the top of the trading range with another leg lower just ahead. But it may be helpful to try to emotionally disengage from the shorter-term moves of DAA and focus on the longer-term picture: this strategy has gotten all the big moves correct in recent decades, and there's no reason to believe it won't get this one right too.