A headline that shook the financial world Friday is Bridgewater Associates, the world’s largest hedge fund, betting more than $1 billion that stock markets around the world will fall by March.
Ray Dalio, the head of Bridgewater, said in a response to the Wall Street Journal report that the firm had no such “net” bet, muddying the waters.
Regardless, this is how prudent investors ought to think about the U.S. stock market.
Note the following:
• The most important point from the chart is divergence in the relative strength index (RSI). This is a huge negative. In plain English, divergence in this case means that while the price has gone up, RSI is now at a lower level.
• RSI divergence indicates loss of internal momentum in the market.
• We have previously written that the market is controlled by the momo (momentum) crowd. A big part of buying in the stock market is not due to fundamentals or macro indicators, but simply because the market is going up.
• Any signal from RSI is a shorter-term signal because it is an oscillator. Oscillators are not very useful for longer-term signals in a bull market.
• The chart is monthly, showing the longer-term trend. The chart includes the crash of 2008.
• From the chart, notice the difference between the stock market performance from the 2000 crash to the 2008 crash, and from the 2008 crash to the present.
• The chart shows the Arora signal to buy stocks aggressively that occurred just before the historic bottom in 2009. The chart also shows the Arora buy signal on Christmas Eve in 2018, which turned out to be the bottom of this swing.
• The chart shows that volume is low. This indicates lack of conviction.
• A big reason behind the buying in the stock market is performance chasing going into year-end, and that may be the reason that Bridgewater has picked the time for a decline before March 2020. Please see “‘Performance chasing’ and Trump’s impeachment process could push the Dow to 30,000” and “Everyone is bullish on stocks all of a sudden — here’s why you shouldn’t be.”
• Bridgewater has about $150 billion in assets.
• Apparently Bridgewater has paid about $1.5 billion for put options.
• This means Bridgewater has used at least 1% of its assets to hedge its portfolio.
• Hedge funds typically use sophisticated strategies with many interrelated positions.
• Hedge funds are typically active and continuously change their assessment of the market. Caution: It is conceivable that the headlines you are reading in the media may be old news.
What does it all mean?
Take another look at the chart, and two things stand out.
1. The stock market has come a long way since the 2009 bottom. Trees do not grow to the sky.
2. At present, the stock market is extended from the trend line shown on the chart. A pullback to the trend line will cause substantial losses for investors but will not change the secular bull market.
Don’t be lulled into the security of popular large-cap stocks such as Apple AAPL, -0.24%, Amazon AMZN, +0.33%, Facebook FB, +0.23% and Microsoft MSFT, -0.13%. Those stocks carry heavy weight in indexes. If major selling starts, it will first be in futures and ETFs. Your favorite stocks will get hit irrespective of their individual merits. Especially vulnerable are popular cloud stocks such as Salesforce CRM, -0.03%, ServiceNow NOW, +0.24% and Workday WDAY, -0.15%. Also vulnerable are semiconductor stocks that have performed well, such as AMD AMD, -0.80%, Micron Technology MU, +0.85%, Nvidia NVDA, +0.17% and Applied Materials AMAT, -0.89%.
It is simply common sense that investors ought to do at least the following six things:
1. Hold a fair amount of cash.
2. Hold some hedges. Investors who are not into hedging, ought to consider holding even more cash.
3. Hold cash in money market funds, CDs, Treasury bills or ultra-short bond funds.
4. Consider staying away from long-dated bonds.
5. Diversify into positions that are not among popular stocks.
6. Diversify by time frames.
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Disclosure: Subscribers to The Arora Report may have positions in the securities mentioned in this article or may take positions at any time. Nigam Arora is an investor, engineer and nuclear physicist by background who has founded two Inc. 500 fastest-growing companies. He is the founder of The Arora Report, which publishes four newsletters. Nigam can be reached at Nigam@TheAroraReport.com.