Shake, Rattle, and Roll…and Bounce

Shake, rattle, and roll… and bounce.  I am not sure that Bill Haley and the Comets would approve of the lyric appropriation but the equity market bulls were certainly dancing to the beat as all of the major indexes soared in yesterday’s session.  The oversold conditions combined with a strong JOLTS economic release and some strong earnings releases prompted the buying.  Recall that the JOLTS number is released monthly by the Bureau of Labor Statistics and tracks job openings. Yesterday’s number came in at 7.136 million openings, which was greater than the expected number of 6.9 million and represents an all time high for the index.  On the earnings front, Morgan Stanley and Goldman Sachs led the group of pre-market releases, both handily beating their expected numbers by 15.5% and 16.8% respectively.  All of these (and a host of other solid earnings releases) reminded traders that the economy is strong and that corporate earnings are healthy.  It also helped that bond yields have receded a bit since spiking earlier in the month allowing investors to fear them a bit less.

So where does that leave us?  Referring to the charts in my attached daily chartbook for highlights, the large cap S&P500 roared back from risk off territory almost into neutral as it crossed over its critical 200 day moving average and a Fibonacci resistance line to close near its highs of the session (chart 4).  The index’s new range will be between the round 2800 and its 2852 Fibonacci line.  The Dow Jones industrials similarly surged by 2.2% almost back into neutral territory and will trade in a new range between Fibonacci lines 25308 and 26030 (chart 6).  The small cap Russell 2000 (of which Siebert Financial is a proud member) capped off two positive sessions closing at its daily high (chart 7).  The Russell traded up by 2.2% possibly marking the beginnings of a trend reversal.  Though the index remains risk off, it must re-trend before the overall equity market can regain its former clean bill of health.  The growth and tech heavy NASDAQ 100 unsurprisingly posted the biggest gain in yesterday’s session trading up 2.9%.  Though the NASDAQ made very positive gains yesterday it traded just shy of its neutral territory.  A close over its Fibonacci resistance line at 7346 would take the index from risk off into neutral.  Yesterday’s buying frenzy extended beyond equities and even bonds traded up. Typically, bonds are negatively correlated to stocks, which means that when stocks go up bonds go down and vice versa… for the most part.  I say that because it is, of course, not always the case but it does hold true over the longer time horizon that most investors possess.  So bonds are not only for fixed incomes but may also serve to diversify an equity portfolio, which in this late cycle economic period, is more critical than ever.  Because it is geek-out Wednesday, I thought I would delve a little deeper into diversification.

Most, if not all, of us have gotten the advice not to put all of your eggs in one basket.  While the saying applies to a broad spectrum of life situations, it is most fitting (in my financial mind at least) for investors.  Let’s go back to the beginning… well almost.  The Bible speaks of it in the book of Ecclesiastes saying “… divide your investments among many places, for you do not know what risks lie ahead”.  Wow, I couldn’t have written that better myself!  Turn the clock forward from 935 BC to the 1950s when Harry Markowitz,  the creator of Modern Portfolio Theory showed us not only the benefits but also how to create a diversified portfolio through asset allocation.  So first the basic concept.  Imagine if you put all of your money in just one stock and that stock performs really well over the course of your investment.  The return on your investment would be high and you would be very happy.  But what if the stock did not go straight up but in fact went down, or worse yet went into bankruptcy?  Everyone talks about how great it would have been to have bought Microsoft in the 1980’s but we must remember that it was considered quite a risky investment at the time and was shunned by many traditional investors.  Investors during that time would have surely favored IBM, General Electric, or perhaps Sears Roebuck.  Well, I am sure that I don’t have to tell you that you would have been far better off with Microsoft.

However, looking back in history you would have seen that it was not all just straight up for Microsoft and that there were times that GE and IBM went up while the now-iconic software company went down.  So if you owned MSFT, GE, and IBM a bumpy ride would have been well, less bumpy.  So you can see that by owning more than one stock, you can lower the volatility and the risk of your portfolio.  OK, so that is simple enough: don’t buy one stock, buy several in case one performs poorly and its shortfalls would be minimized by the group.  Imagine now, if you will, a scenario in which you own lots of stocks and the whole stock market goes down?  We have another saying on Wall Street for that: “a rising tide lifts all boats”, well in this case the opposite would be true as all ships would also go down with the ebb tide.  So it is clear that we need to consider other kinds of investments outside the stock market.  An easy place to start would be the bond market.  Historically, as mentioned above, bonds go up when stocks go down, and vice versa.  So if you owned a portfolio of stocks and bonds during a period of stock bull market your return during that period would be lower than if you owned only stocks but you will have less downside risk when the bull market gives way to a bear market in which all stocks go down.  In a bear market, bonds tend to go up and can minimize losses incurred in the stock portion of your portfolio.  A portfolio that includes stocks and bonds is very common and has been used by savvy, high net worth investors for many years.

But what about the rest of us?  Mutual funds were the first to provide ordinary investors with the ability to own stocks and bonds without having to buy the securities themselves.  Eventually Mutual Funds gave way to Exchange Traded Funds (ETF’s), which offer a lower cost, more transparent, more liquid vehicle to investors.  In fact there are ETFs that invest in all different types of asset classes with a high level of focus.  So now, an investor can truly diversify a portfolio by say, investing in foreign markets as well, so if the domestic markets are under-performing perhaps the better performing foreign markets will be more stable.  In fact because of the broad array of specialized funds available, investors can invest in different size companies, different investment styles, alternative assets like real estate or commodities, and even individual sectors or industries.  The list goes on and on but it is clear that diversification allows investors to protect their capital and minimize their risk in all market conditions.  This concept of diversification is known as asset allocation in which an investor allocates certain portions of their portfolio to different, or diverse, asset classes in order to create an overall optimal portfolio.  This is where my Modern Portfolio Theory (and a whole lot of complicated math comes in).  I will spare you the math but I will give you the highlights.  The first thing to consider is the relationship between all of the assets in the portfolio.  We clearly want to consider assets that are not correlated, meaning that if one goes down the other doesn’t.  This allows us to minimize the overall volatility and risk in the portfolio. Here comes the tough part.  We have to take risk in order to get a reward, however we want to make sure that we are getting the most amount of return possible for the least amount of risk. What?  Imagine if I offer you two investment opportunities that both are expected to return 2%. Investment A will be very stable over the life of the investment but Investment B will be all over the place with extreme highs and lows.  Which investment would you pick?  Modern Portfolio Theory provides us with the necessary mathematical framework to create a diversified portfolio that maximizes returns while simultaneously minimizing risk.  As you might have guessed by now, every investor has a different appetite for risk.  For example, investors who are close to retirement and will rely on their investments for income in the near future would most likely go for a lower risk portfolio that would offer lower returns in exchange for lower risk of capital losses.

Younger investors, who are in their wealth accumulation stage, are willing to tolerate more volatility in exchange for the potential to get a greater long term return.  Because they are farther away from requiring the funds, they will be able to ride out the ups and downs of the markets.  Modern Portfolio Theory also provides a mechanism to create optimal portfolios in varying levels of risk. So there is something for each investor’s risk tolerance.  Finally, expected returns, risk levels, and correlations change over time and so does the optimal allocation making it important to re-evaluate a portfolio on a timely basis.  So summing it all up:  diversification allows investors to minimize risk of capital loss.  Creating a diversified portfolio can be achieved by using different asset classes that are not correlated and can be created to minimize risk while simultaneously maximizing returns using Modern Portfolio Theory techniques. It is important to select a portfolio whose risk matches your investment objectives and your risk appetite.  Lastly, investment objectives change over time as do the markets, so it is important to constantly manage the process to ensure the best outcome.  The best way to achieve all of this is to engage your financial advisor.  At Siebert AdvisorNXT, our wealth managers have access to portfolio management tools and experts that will help you select the right blend of investments for achieving your goals.

Today, we have another day full of releases beginning with housing starts and building permits. Housing starts are expected to have fallen by -5.6% month over month after having risen 9.2% in the prior period.  Building permits however are expected to have grown by +2.0% month over month.  As I have been mentioning in prior notes, housing numbers are starting to become more critical as rates go up.  The rising rates will certainly impact the housing market that is so reliant on finance and it is usually one of the first indicators of economic slowdown.  Later in the day we will get the meeting minutes from the last Federal Open Market Committee meeting.  While we know what they agreed on, traders will parse the minutes carefully to get a better understanding of the Fed’s logic and thoughts on future rate hikes.  The minutes are released this afternoon at 2:00 PM Eastern and will surely serve to add some volatility to the already jumpy markets.  Taking center stage again today will be corporate earnings from today’s pre-market and yesterday’s post-market. Yesterday’s after-market releases included Netflix, which beat expectations while IBM missed. Good if you own NFLX, bad if you own IBM, and probably best if you own a bit of both along with a bunch of other assets classes.  Because, as you know well by now, diversification is the key to minimizing risk in all market conditions.  Thank you for reading and please check back daily for news, commentary, daily releases, and a bit of geeky humor.

daily chartbook 2018-10-17