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Stocks and Bonds Have Reached an Elevated Risk Level as Tomorrow Starts the First Day of the Seasonal Santa Claus Rally Thumbnail

Stocks and Bonds Have Reached an Elevated Risk Level as Tomorrow Starts the First Day of the Seasonal Santa Claus Rally

When the wind is blowing, we can sit back and enjoy the ride, but when the wind stops blowing, we have a decision to make. We can sit there and hope the wind starts blowing and risk sinking, or we can get out the oars and start rowing. 

I wrote that for the first time twenty years ago, as I was preparing to launch Shell Capital Management, L.L.C., and register the firm as an investment advisor.

The mission was to row, not sail.

That is, to focus our efforts on rowing, not sailing. 


What's the most difficult part of sailing? 

When asked on Quora, someone replied:

"Sailing is a dynamic experience with ever-changing variables. Wind, current, waves, shallows, obstacles, and other boats, to name a few. The most difficult part of sailing is adjusting to the conditions in a safe and concise manner. Keeping the boat moving is extremely critical. Without movement, there is no steering, and unless intentionally trying to stop the boat, this is a vulnerable position."

He goes on to say,

"Choosing the right sails and configuration for the conditions is a more complicated discussion."

So, sailing itself isn't so easy, as the sailor must dynamically adjust to changing conditions to use the power of the wind in the sail. But when the wind stops blowing, it doesn't matter what you do with the sails. 

It's an imperfect analogy, but you probably get the drift.

Rather than a passive allocation to indexes or funds, we continuously measure the direction and speed of the wind to adjust our sails accordingly, and we'll get out the oars and start rowing as needed. 

We don't just sit there; we do something, even with no guarantee that those efforts will get us where we want to be each and every time we do it. We have a mathematical basis for believing we should. 

Right now, by my measures, both the stock and bond markets have gotten overbought in the short term. 

For example, I've shared below the S&P 500 Equal-Weight stock index which equally rates the ~500 stocks in the index for a broad measure of participation.

The stock index trended above its prior highs, and it's done so with strong momentum as measured by its own relative strength, which is extended on the upside to reflect the buying pressure. Although strong momentum is a good thing, too much too fast increases the odds the buying enthusiasm may be nearing an end. 

Another indication I included on the chart is the percent of S&P 500 stocks in an uptrend as measured by being above their 50 and 200-day average prices. The percent of stocks above their 50 or 200-day average is a measure of breadth of participation, so the current level of 90% of the stocks in the index above their own 50 day moving average is a very positive indication for what stocks have recently done. When these measures reach an extreme, it can be an early warning that the next move may flip in the other direction. Both of these measures have reached such an extreme we shouldn't be surprised to see the demand for stocks fade temporarily. 

The last chart is the Cboe Implied Volatility Index (VIX) which is a popular measure of expected volatility for the next 30 days based on the pricing of options. Implied volatility tends to drift like the markets, but once it reaches an extreme level, the VIX is prone to counter-trend and mean-revert. The current level in the 12's is at the low end of its historical range and indicates extremely low expectations for S&P prices to spread out over the next few weeks. 

And the Fear & Greed Index, which uses the VIX as one of seven indicators it follows, has reached "Extreme Greed" as the emotion driving the market. 

Although the Fear & Greed Index can remain high for a while like it did last time, it's a warning shot across the bow.

Why does it matter? 

If we want to realize some profits, we can sell to reduce our exposure to the possibility of loss. These low VIX levels and indications of complacency also suggest listed options have a good relative value for those who trade options to gain exposure or to hedge. 

What may keep the trend going?

At the start of December, I pointed out on X

"The market is setting up for a Santa Claus rally. The market tends to trend down in the first part of December, then a Santa Claus rally starts five days before Christmas and ends five days after Christmas.

Since optimism has returned,  a seasonal decline that unwinds the optimism could set the stage for a Santa Claus rally at year's end."

It seems the rally came sooner since the stock indices have gained 3-4% since then, but tomorrow marks the first day of the seasonal expected Santa Claus Rally, so there may be higher prices and even more overbought markets before a snapback.

What if I'm long-term?

Short-term trends are a necessary ingredient of long-term trends, so if you're a loss-averse investor, the process of limiting downside losses starts with short-term action. 

It isn't easy; we're dealing with uncertainty, and there's no guarantee, so the best we can do in pursuit of asymmetric investment returns is stack the odds in our favor. This is a glimpse of the thinking behind how we do it. 

Mike Shell is the founder, President, and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of Asymmetry® Managed Portfolios.  Shell Capital Management, LLC is a registered investment advisor focused on asymmetric risk-reward and absolute return strategies. Shell Capital provides investment advice and portfolio management to clients with separate accounts at Goldman Sachs Advisor Solutions with an investment management agreement. The observations shared on this website are for general information only and should not be construed as investment advice to buy or sell any security. This information does not suggest in any way that any graph, chart, or formula offered can solely guide an investor as to which securities to buy or sell, or when to buy or sell them. Securities reflected are not intended to represent any client holdings or recommendations made by the firm. In the event any past specific recommendations are referred to inadvertently, a list of all recommendations made by the company within at least the prior one-year period may be furnished upon request. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities on the list. Any opinions expressed may change as subsequent conditions change. Please do not make any investment decisions based on such information, as it is not individualized advice and is subject to change without notice. Investing involves risk, including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results. All information and data are deemed reliable but are not guaranteed and should be independently verified. The presence of this website on the Internet shall in no direct or indirect way raise an implication that Shell Capital Management, LLC is offering to sell or soliciting to sell advisory services to residents of any state in which the firm is not registered as an investment advisor. If this website contains information regarding Options Trading, please read the Characteristics & Risks of Standardized Options, also known as the options disclosure document (ODD). Options involve risk and are not suitable for all investors. The views and opinions expressed in Asymmetry® Observations and Asymmetric Investment Returns are those of the authors and do not necessarily reflect the position of Shell Capital Management, LLC. The use of this website is subject to its terms and conditions.