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Finding an Equity Position as Volatility Looms


ED LOPEZ: How do you manage equity risk in an environment where equities have entered the ninth year of a bull market and volatility has begun to raise its head? I’m Edward Lopez, Head of ETF Product at VanEck. And I’ll be discussing this topic and an idea for a solution with Steve Blumenthal, Executive Chairman and CIO of CMG Capital Management Group and Robert Schuster, Senior Director at Ned Davis. Gentlemen, thank you for joining me. Steve, our advisors and investors are in kind of a tough spot right now with the market continuing in its march higher after nine years, and volatility now beginning to pick back up. The question seems to be: Do I keep allocating to equities and risk a major drawdown? Or do I pull back and miss continued growth?


STEVE BLUMENTHAL: The market is extremely overvalued, overpriced. It tells us very little about whether we move higher this year or lower. But it tells us an awful lot about what returns are going to look like over the next 7 to10 years. When things are expensively priced, the forward returns are low. When they’re inexpensively priced, the forward returns are high. So we’re at a point in a very aged bull market that’s expensively priced. Expect lower returns.


LOPEZ: CMG teamed up with Ned Davis and you guys created an index which offers a solution for this type of conundrum and this type of scenario. It’s the Ned Davis Research CMG US Large Cap Long/Flat Index. Robert, can you tell us a little bit about that index?


ROBERT SCHUSTER: Ed, the model’s built on the premise that we can use S&P industries to help gauge the health of the market. We measure if the market is in gear and healthy or whether it’s out of gear and is highly at risk. What we do is incorporate 22 S&P indices and we create individual models. And those individual models are then combined into an aggregate, single composite that tells us the health of the market. However, we add a component to that. We look at the direction of the model itself, the composite, and based on that direction, that gives us our allocation to equities and cash.


BLUMENTHAL: I would add that, if you look at these 22 sectors, there may be a period where one sector is out of gear, but the other sectors are doing well. We’re looking for the overall weight of health of the market to determine this model composite score. And when things are very healthy, we want to be in the market. When things start to deteriorate, depending on how much deterioration we see in this model composite, the weight of evidence across 22 sectors, we start to de-risk.


LOPEZ: From the standpoint of the model and how it works, you talked about it stepping out in 2017. Early this year in 2018 there was a 10% correction in the market, but it stayed in 100%. Can you talk a little bit about why that happened and a little bit more detail about the methodology behind that and how that runs?


SCHUSTER: What happens is the underlying composite with these indices is, again, cap weighted. Those are cap-weighted indices. A lot of the stronger bigger cap indices were a little bit stronger, and the model itself sort of hovered. It sort of hovered around a particular zone, about 65-72, for about six months. The directional component has just stayed positive. That shows the strength that it had earlier. It’s just maintaining a positive position. Now what will happen is, if that direction starts turning down, and over the last couple of days it’s sort of inching down, but it’s not negative yet, but if we’re below 70 and the direction turns negative, then this model will go to an 80% equity, 20% cash position.


LOPEZ: Robert, from Ned Davis’ economist standpoint, you look at fundamental and macro pictures as well. What’s their take on the market for 2018, and does that differ from how the model is positioned today?


SCHUSTER: At Ned David Research we’re overweight equities in our global asset allocation. We’re positive on the U.S. market. We think it will be up by the end of the year. However, we do identify risk. We do think there’s going to be more volatility this year than there has been certainly last year. So we take that all into account. At the end of the day, we still are bullish on the overall market. Even within some of our processes that we look at and the models that we look at and what we pay attention to, we look at certain markets, and they can be what we call risk on. They’re higher beta. They take on the appetite of risk. Of those markets that we measure, over 60% of them are above their 200-day moving average. On the risk-off markets, only 20% are above their 200-day moving average. That’s indicative of a market that has an appetite for risk. So even within some of our own research that we’re doing that’s separate from this particular model, it’s still indicating something that’s pretty parallel to what that model is saying as well.


LOPEZ: From an index construction standpoint, you mentioned that it looks at the individual industries and it’s market-cap weighted. Right now technology has been on a bit of a tear over the last few years, and especially this year. Would that have to really come off for this model to move into a de-risk scenario?


SCHUSTER: It would be a combination of your bigger cap industries or sectors and components of the sectors. But, again, because there are 22 industries out there, it’s really a weight of the evidence. What’s going to drive it is the majority of indices really sort of starting to turn down. If one industry starts turning down, it’s not going to necessarily drive it to a sell signal. There’s got to be, again, breadth. There’s got to be an abundance of de-risking across the board, not just within one particular sector.


BLUMENTHAL: To your point, Ed, if you think about 1999, something like 40% of the exposure in the S&P 500 was to technology stocks. So the model is built in a way that factors that more in the model equity line because it’s cap weighted in how we view things. So there is an element that does do it, but we clearly look across the 22 subsectors.


LOPEZ: Steve, you’re an advisor, how would you characterize the state of the U.S. equity market today and how are you interacting with clients now? Are you getting calls right now given some of the recent volatility?


BLUMENTHAL: I just came from a big investment conference on the West Coast and there were some outstanding keynote speakers that presented. One of them is David Rosenberg who years ago was at Merrill Lynch and he was an all-star analyst and I’d always listen in to whatever he had to say. So I enjoy his thinking. His advice is to raise 25% cash. I think that that’s a hard thing for most advisors to do. I’m not saying it’s the wrong thing to do here, but that’s a hard thing to do. Instead, the way that I build the models within our firm, my team, is that we look at how much exposure we want to have to the equity market, to the fixed income market, and to various different sorts of active risk-managed trading strategies. We think in terms of three buckets. In the equity bucket I have our long/short strategy as a component for the large-cap exposure. But we also have a global exposure. And we also have a tactical equity exposure. So we look at diversifying to these different exposures. I find it really hard to be able to go back and say: “I’ve put 25% of your money into cash.” That’s going to be a hard conversation if the market continues to accelerate higher. But the risks are incredibly elevated. I think that the downside is significant. I just want to make sure that I have opportunity to seek growth, but also to do it in a way that can meaningfully protect the downside. So I like to combine different risk-managed processes into the exposures.


LOPEZ: Gentlemen, thank you very much. VanEck has an ETF based on the Ned Davis Research CMG US Large Cap Long/Flat Index, it’s called VanEck Vectors NDR CMG Long/Flat Allocation ETF, ticker symbol LFEQ.


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