Our model does not foresee a significant correction on the horizon. Hence, the optimal decision is to follow our model, be 100% long stocks, and ignore all potential “small corrections”.
However, we sold our UPRO (3x S&P 500 ETF) on May 23 and have been sitting on 100% cash ever since because from a historical perspective, the risk of a small correction is high. By trying to avoid small rallies, we shrink our investment performance but reduce our portfolio’s volatility even more.
The S&P was at 2392 on May 23. The current “small rally” has lasted longer than 96% of all historical small rallies. If the S&P doesn’t make a “small correction” by late-October 2017, this will be the longest small rally in history.
*The last small correction was in June 2016.
So the question is, could 2017 shape up to be like 1995? The U.S. stock market soared in 1995. It rallied steadily and incessantly and did not make a “small correction” in 1995. Is it possible that the S&P won’t make a small correction this year? Will the current “small rally” become the longest “small rally” in history?
Here’s the S&P 500 in 1995.
There are similarities between today and 1995
If you study history, you’ll realize that the S&P 500 always rallies the fiercest during years that are “quiet”.
- In a bull market, the stock market has a natural bullish bias. With rising corporate profits and a growing economy, the market naturally goes up over time.
- When the market (majority of investors) sees no real fears/uncertainties, the stock market soars. These are the “quiet” years.
- The stock market’s rally is exceptionally steady and incessant.
The S&P soared 35% in 1995. Here’s why the stock market’s rally in 1995 was exceptionally fierce.
- 1995 was a “quiet” year. The media was awfully quiet in 1995 because there weren’t many real bearish stories to talk about!
- 1995 was the start of the internet boom. Netscape IPO’ed in 1995.
- Corporate earnings boomed.
- Just like today, there was a downturn in the economic data in late 1995. However, this did not damper the stock market’s rally at all. History shows that transitory downturns in the economic data have no consistent bearish impact on the stock market.
- The market rallied nonstop without any 6%+ “small corrections”.
There are many similarities to today.
- Yes, there is some transitory weakness in the U.S. economic data. However, this weakness is not even close to being significant enough to cause a significant correction in stocks. This transitory weakness doesn’t have to result in a small correction for the S&P 500.
- 2017 is shaping up to be a quiet year. Mueller’s Trump-Russia investigation will release details next year, not in 2017. The market hasn’t cared about all the “reports” on Trump by the Washington Post / New York Times. If Trump doesn’t pass any pro-growth policies, the stock market will still go up in the long run because the economy is improving. Any pro-growth policies that Trump does pass will merely be additional icing on the cake. Major European uncertainties are over (Brexit is old news – no one cares anymore). Trump’s potential trade wars are no more. Everyone knows that the debt ceiling is just a joke.
- Investors know that the decline in oil prices is not a major concern. Historically, U.S. shale production costs have been the floor for oil prices. In early-2017, U.S. shale cost $37-$38 a barrel. But with rising acreage and labor costs, U.S. shale now costs more than $40 a barrel. So even if oil falls below $40, it will most likely be transitory price weakness.
- Corporate earnings are soaring right now. 12 month forward EPS for the S&P is growing at 0.3-0.4% per week (around 15-20% per year).
What is the difference between 1995 and 2013?
The U.S. stock market soared in 2013 (up 30%). In fact, 2013 was very similar to 1995. The stock market soared because it was a “quiet year” without any major worries. There were some minor worries like the debt ceiling in 2013, but investors knew that those minor worries were not major uncertainties.
Here is the S&P in 2013.
In fact, 2013 and 1995 were almost exactly the same, except the S&P made a small correction in 2013. These small corrections happen for no fundamental reasons. It was merely profit taking within a bull market.
So will 2017 be like 2013 or 1995?
Who knows. Based on the stock market’s steady rally year-to-date, this thing can go either way. And 2013/1995 aren’t even that different. In a quiet year, it’s impossible to guarantee that the stock market will make a 6% “small correction”.
There are still 6 months left in 2017. As the year progresses, perhaps a bearish theme(s) will emerge. Hence, we’ll set the odds of 2017 being like 2013 at 70% and the odds of 2017 being like 1995 (i.e. no small correction) at 30%.
What will we do if the stock market doesn’t make a “small correction” this year?
This is the beauty of our trading strategy. When we shift from cash and buy stocks, we always go 100% long UPRO (3x S&P 500 ETF). Hence, we don’t always have to be in the market. The fat years will more than make up for lean years.
We’re already up 17% year-to-date.
Let’s assume that the S&P doesn’t make a small correction this year. It will have to make a small correction in the first half of 2018. Yes, this “small rally” can set a new all time record, but it cannot go on setting records forever. Profit taking is a natural part of bull markets. Low volatility periods do not last forever.
If the stock market makes a 6%+ small correction in early-2018, we buy UPRO, and then the S&P makes a new all time high, our portfolio will be up 19-20% right from the start of 2018. Then as the S&P continues to rally in 2018, our performance will outperform the S&P by 3x.
As an investor, you need to have a target performance. Ours is 20% per annum. If we don’t hit our target this year, it’s almost guaranteed that we will exceed our target next year.
The big and less-risky money is made by sitting tight and waiting for the best investment opportunities. This is why we outperform so many other hedge funds. Most hedge funds are slaves to short term performance – they have to make money quarter after quarter. We don’t. We only need to focus on long term performance.