The "State of the Markets"
As we embark on a fresh new calendar year (aka the scorecard in our business), the question of the day is – in my mind, in my mind, anyway – will the bears will be able to locate their long-lost mojo anytime soon?
To be sure, it has been a while (a very long while, actually) since our furry friends have enjoyed more than a day or two in the sun. So, with the market having effectively been a one-way street since the November 2016 election, it is easy to see why complacency is exceptionally high, passive index investing is all the rage, and every 1% dip in the S&P 500 is considered a buying opportunity.
While nearly everyone in the game knows that when you mix extreme valuations levels with rising rates, bad things tend to happen – eventually. And yet, the bulls have refused to yield the floor for record-setting stretches. Recall that this is now the longest period of time without a 3% correction in decades and that markets cycles experiencing volatility levels this low are exceptionally rare. As such, every trader worth their salt has been waiting (and waiting, and waiting, and waiting!) for the inevitable pullback to begin.
So, will this market once again ignore the seasonal tendencies and correct a bit to start the new year? Or will it be more of the same? Unfortunately, only time will tell, of course! But, I for one am going to be prepared for anything in the first few weeks of the year.
My Big-Picture Bottom Line - I see enough weakness in the indicators and enough complacency to continue to suggest that this is not a low-risk environment.
In terms of investing strategy, this means that your portfolio turbo-chargers should be moved to the "off" position and that taking your risk profile down a notch makes a great deal of sense.
No, this does not mean that you need to immediately exit stage left. And this does not mean that the stock market won't continue to rally.
What I am saying is that going into 2018, you may want to "take it down a notch." I.E. Consider strategies to reduce the overall beta of your portfolio.
For example, in my opinion, this is not a time to be levered long. In addition, you may want to consider reducing any big overweights to sectors, styles, factors etc – especially those that tore it up in 2017. Next, take a look at your security holdings. If you want to be long stocks, consider looking at a broad market index versus the current leaders such as the NASDAQ 100.
The key is to recognize that at some point (and, for the record, I have no idea when) the bears will eventually rediscover their mojo. At some point, the current cyclical bull market (which turns 2 years old in February) will end – or at the very least, experience an interruption. And at some point, my guess is the market will experience a very swift and very sharp decline. (Or not – LOL!)
As such, I believe this is a great time to avoid falling victim to the herd mentality and to make sure your risk management tools are dusted off and at the ready.
The State of the Big-Picture Market Models
Let's start with my "executive summary" of the state of the market - I.E. a review my favorite big-picture market models, which are designed to tell us which team is in control of the prevailing major trend.
- The Leading Indicators model, which was our best performing timing model during the last cycle, had faltered recently but starts the new year in pretty good shape.
- We have recently upgraded our "State of the tape" model to include an additional 5 indicator readings. While the current reading of the new model is technically positive, the current reading is not going in the right direction and not exactly robust.
- The Risk/Reward model is currently rated neutral. However, this is due to the model's emphasis on both monetary and sentiment conditions. And since the current monetary environment is unique, I can argue that a "yea but" can be applied here.
- If I had to manage money from a desert island and could only use one model, it would be this one - a combination of internal and external factors. Currently, the model remains on a long-term buy signal, however, the model reading has been flip-flopping back and forth (and back and forth) lately. This remains something to watch and is the basis for my thesis that this is not a low-risk environment.
- The newly expanded External Factors model includes a total of 10 indicators ranging from earnings, yields, sentiment, monetary, economic, and volatility. The current model reading is slightly - but only modestly so.
- The historical average gains seen from the market given the current readings of the models shown on this board is more than double the historical average.
The State of the Trend
Digging into the details, I like to start my weekly review with a look at the "state of the trend." These indicators are designed to give us a feel for the overall health of the current short- and intermediate-term trend models.
- Although the last hour selling that tends to occur fairly often at the end of calendar year periods could be quickly reversed in the New year, the action caused the short-term Trend Model to be downgraded to neutral. A break below 2650 would turn this model red.
- The short-term Channel Breakout System remains on a buy signal. However, the recent stall in the action has allowed this trend system's stop point to become close at hand.
- The intermediate-term Trend Model remains positive.
- The intermediate-term Channel Breakout System is also green here. And while the s.t. version of this system could easily flash a sell signal if there is further weakness, the intermediate system's stop currently is down around 2605.
- The long-term Trend Model continues to sport a bright shade of green.
- The Cycle Composite likes the early part of the year.
- The Trading Mode models tell us to give the bulls the benefit of the doubt in this trending environment.
The State of Internal Momentum
Next up are the momentum indicators, which are designed to tell us whether there is any "oomph" behind the current trend.
- Both the short- and intermediate-term Trend and Breadth Confirm Models are positive this week.
- The short-term Trend and Breadth Confirm Model slipped into the neutral zone. This is an indication that momentum has faltered.
- Our intermediate-term Trend and Breadth Confirm Model, which has done a very good job calling the trend lately, remains positive.
- The outright positive reading of our Industry Health Model didn't last long as the model slipped back into the moderately positive zone.
- Although still positive, the short-term Volume Relationship is starting to roll over here. This is a warning sign that the bears might be able to enjoy some time in the sun.
- The good news for the bulls is the intermediate-term Volume Relationship is in good shape.
- The Price Thrust Indicator has weakened considerably but is still sporting a green light.
- The Volume Thrust Indicator starts the week dead neutral. This is a very good assessment of the overall environment.
- Ditto for the Breadth Thrust Indicator - dead neutral.
- It is important to recognize that momentum has stalled over the past two weeks.
The State of the "Trade"
We also focus each week on the "early warning" board, which is designed to indicate when traders might start to "go the other way" -- for a trade.
- From a near-term perspective, our oscillator signal just flashed red.
- From an intermediate-term view, stocks remain very overbought. However, unless/until the bears find their long-lost mojo, I'll call this a "good overbought" condition from an intermediate-term perspective.
- The Mean Reversion Model is VERY close to issuing a sell/short signal. However, it has been tough for the model to trigger a signal in either direction in this low volatility environment, so I wouldn't jump the gun here.
- The short-term VIX indicator reading has finally popped enough to where a reversal in vol will trigger a buy signal.
- Our longer-term VIX Indicator remains on a buy signal and stuck in neverland at the moment.
- From a short-term perspective, the market sentiment model is currently rated low-neutral.
- The intermediate-term Sentiment Model remains solidly negative.
- Ditto for the Longer-term Sentiment readings.
- The message from this board is stocks remain overbought and sentiment is very complacent. As such, the table is set for the bears - IF they can find their mojo.
The State of the Macro Picture
Now let's move on to the market's "external factors" - the indicators designed to tell us the state of the big-picture market drivers including monetary conditions, the economy, inflation, and valuations.
- Absolute Monetary conditions didn't budge last week - the model is stuck at dead neutral.
- However, the reading of the Relative Monetary Model took a pretty big hit last week and finds itself in the neutral zone here. Note that stocks have gained ground at an annualized rate of nearly 24% per year when this model is positive and just 5.2 when neutral.
- Our Economic Model continues to suggest a strong economic growth environment.
- Although the reading of the Inflation Model has begun to turn, the model continues to suggest a fairly constructive environment for stocks.
- The Absolute Valuation Model, which employs GAAP earnings, remains at very negative levels.
- Our Relative Valuation Model, which incorporates the level of interest rates remains neutral, albeit by the skinniest of margins.
Sample Risk Exposure System
Below is an EXAMPLE of how some of above indicators might be used in order to determine exposure to market risk. The approach used here is a "Model of Models" comprised of 10 independent Models. Each model included gives separate buy and sell signals, which affects a percentage of the model's overall exposure to the market.
Trend models control a total 40% of our exposure. The 3 Momentum Models and 3 Environment Models each control 10% of the portfolio's exposure to market risk. The model's "Exposure to Market Risk" reading (at the bottom of the Model) acts as an EXAMPLE of a longer-term guide to exposure to market risk.
In looking at the "bottom line" of this model, my take is that readings over 75% are "positive," readings between 50% and 75% are "moderately positive," and readings below 50% should be viewed as a warning that all is not right with the indicator world.
The model above is for illustrative and informational purposes only and does not in any way represent any investment recommendation. The model is merely a sample of how indicators can be grouped to create a guide to market exposure based on the inputs from multiple indicators/models.
Thought For The Day:
Happiness can be found in the darkest of times, if one only remembers to turn on the light. -Unknown
Current Market Drivers
We strive to identify the driving forces behind the market action on a daily basis. The thinking is that if we can both identify and understand why stocks are doing what they are doing on a short-term basis; we are not likely to be surprised/blind-sided by a big move. Listed below are what we believe to be the driving forces of the current market (Listed in order of importance).
1. The State of the Economy
2. The State of Fed Policy
3. The State of Earnings Growth
Short-Term Trend-and-Breadth Signal Explained: History shows the most reliable market moves tend to occur when the breadth indices are in gear with the major market averages. When the breadth measures diverge, investors should take note that a trend reversal may be at hand. This indicator incorporates NDR's All-Cap Dollar Weighted Equity Series and A/D Line. From 1998, when the A/D line is above its 5-day smoothing and the All-Cap Equal Weighted Equity Series is above its 25-day smoothing, the equity index has gained at a rate of +32.5% per year. When one of the indicators is above its smoothing, the equity index has gained at a rate of +13.3% per year. And when both are below, the equity index has lost +23.6% per year.
Channel Breakout System Explained: The short-term and intermediate-term Channel Breakout Systems are modified versions of the Donchian Channel indicator. According to Wikipedia, "The Donchian channel is an indicator used in market trading developed by Richard Donchian. It is formed by taking the highest high and the lowest low of the last n periods. The area between the high and the low is the channel for the period chosen."
Intermediate-Term Trend-and-Breadth Signal Explained: This indicator incorporates NDR's All-Cap Dollar Weighted Equity Series and A/D Line. From 1998, when the A/D line is above its 45-day smoothing and the All-Cap Equal Weighted Equity Series is above its 45-day smoothing, the equity index has gained at a rate of +17.6% per year. When one of the indicators is above its smoothing, the equity index has gained at a rate of +6.5% per year. And when both are below, the equity index has lost -1.3% per year.
Industry Health Model Explained: Designed to provide a reading on the technical health of the overall market, Big Mo Tape takes the technical temperature of more than 100 industry sectors each week. Looking back to early 1980, when the model is rated as "positive," the S&P has averaged returns in excess of 23% per year. When the model carries a "neutral" reading, the S&P has returned over 11% per year. But when the model is rated "negative," stocks fall by more than -13% a year on average.
Cycle Composite Projections: The cycle composite combines the 1-year Seasonal, 4-year Presidential, and 10-year Decennial cycles. The indicator reading shown uses the cycle projection for the upcoming week.
Trading Mode Indicator: This indicator attempts to identify whether the current trading environment is "trending" or "mean reverting." The indicator takes the composite reading of the Efficiency Ratio, the Average Correlation Coefficient, and Trend Strength models.
Volume Relationship Models: These models review the relationship between "supply" and "demand" volume over the short- and intermediate-term time frames.
Price Thrust Model Explained: This indicator measures the 3-day rate of change of the Value Line Composite relative to the standard deviation of the 30-day average. When the Value Line's 3-day rate of change have moved above 0.5 standard deviation of the 30-day average ROC, a "thrust" occurs and since 2000, the Value Line Composite has gained ground at a rate of +20.6% per year. When the indicator is below 0.5 standard deviation of the 30-day, the Value Line has lost ground at a rate of -10.0% per year. And when neutral, the Value Line has gained at a rate of +5.9% per year.
Volume Thrust Model Explained: This indicator uses NASDAQ volume data to indicate bullish and bearish conditions for the NASDAQ Composite Index. The indicator plots the ratio of the 10-day total of NASDAQ daily advancing volume (i.e., the total volume traded in stocks which rose in price each day) to the 10-day total of daily declining volume (volume traded in stocks which fell each day). This ratio indicates when advancing stocks are attracting the majority of the volume (readings above 1.0) and when declining stocks are seeing the heaviest trading (readings below 1.0). This indicator thus supports the case that a rising market supported by heavier volume in the advancing issues tends to be the most bullish condition, while a declining market with downside volume dominating confirms bearish conditions. When in a positive mode, the NASDAQ Composite has gained at a rate of +38.3% per year, When neutral, the NASDAQ has gained at a rate of +13.3% per year. And when negative, the NASDAQ has lost at a rate of -8.5% per year.
Breadth Thrust Model Explained: This indicator uses the number of NASDAQ-listed stocks advancing and declining to indicate bullish or bearish breadth conditions for the NASDAQ Composite. The indicator plots the ratio of the 10-day total of the number of stocks rising on the NASDAQ each day to the 10-day total of the number of stocks declining each day. Using 10-day totals smooths the random daily fluctuations and gives indications on an intermediate-term basis. As expected, the NASDAQ Composite performs much better when the 10-day A/D ratio is high (strong breadth) and worse when the indicator is in its lower mode (weak breadth). The most bullish conditions for the NASDAQ when the 10-day A/D indicator is not only high, but has recently posted an extreme high reading and thus indicated a thrust of upside momentum. Bearish conditions are confirmed when the indicator is low and has recently signaled a downside breadth thrust. In positive mode, the NASDAQ has gained at a rate of +22.1% per year since 1981. In a neutral mode, the NASDAQ has gained at a rate of +14.5% per year. And when in a negative mode, the NASDAQ has lost at a rate of -6.4% per year.
Short-Term Overbought/sold Indicator: This indicator is the current reading of the 14,1,3 stochastic oscillator. When the oscillator is above 80 and the %K is above the %D, the indicator gives an overbought reading. Conversely, when the oscillator is below 20 and %K is below its %D, the indicator is oversold.
Intermediate-Term Overbought/sold Indicator: This indicator is a 40-day RSI reading. When above 57.5, the indicator is considered overbought and when below 45 it is oversold.
Mean Reversion Model: This is a diffusion model consisting of five indicators that can produce buy and sell signals based on overbought/sold conditions.
VIX Indicator: This indicator looks at the current reading of the VIX relative to standard deviation bands. When the indicator reaches an extreme reading in either direction, it is an indication that a market trend could reverse in the near-term.
Short-Term Sentiment Indicator: This is a model-of-models composed of 18 independent sentiment indicators designed to indicate when market sentiment has reached an extreme from a short-term perspective. Historical analysis indicates that the stock market's best gains come after an environment has become extremely negative from a sentiment standpoint. Conversely, when sentiment becomes extremely positive, market returns have been subpar.
Intermediate-Term Sentiment Indicator: This is a model-of-models composed of 7 independent sentiment indicators designed to indicate when market sentiment has reached an extreme from an intermediate-term perspective. Historical analysis indicates that the stock market's best gains come after an environment has become extremely negative from a sentiment standpoint. Conversely, when sentiment becomes extremely positive, market returns have been subpar.
Long-Term Sentiment Indicator: This is a model-of-models composed of 6 independent sentiment indicators designed to indicate when market sentiment has reached an extreme from a long-term perspective. Historical analysis indicates that the stock market's best gains come after an environment has become extremely negative from a sentiment standpoint. Conversely, when sentiment becomes extremely positive, market returns have been subpar.
Absolute Monetary Model Explained: The popular cliché, "Don't fight the Fed" is really a testament to the profound impact that interest rates and Fed policy have on the market. It is a proven fact that monetary conditions are one of the most powerful influences on the direction of stock prices. The Absolute Monetary Model looks at the current level of interest rates relative to historical levels and Fed policy.
Relative Monetary Model Explained: The "relative" monetary model looks at monetary indicators relative to recent levels as well as rates of change and Fed Policy.
Economic Model Explained: During the middle of bull and bear markets, understanding the overall health of the economy and how it impacts the stock market is one of the few truly logical aspects of the stock market. When our Economic model sports a "positive" reading, history (beginning in 1965) shows that stocks enjoy returns in excess of 21% per year. Yet, when the model's reading falls into the "negative" zone, the S&P has lost nearly -25% per year. However, it is vital to understand that there are times when good economic news is actually bad for stocks and vice versa. Thus, the Economic model can help investors stay in tune with where we are in the overall economic cycle.
Inflation Model Explained: They say that "the tape tells all." However, one of the best "big picture" indicators of what the market is expected to do next is inflation. Simply put, since 1962, when the model indicates that inflationary pressures are strong, stocks have lost ground. Yet, when inflationary pressures are low, the S&P 500 has gained ground at a rate in excess of 13%. The bottom line is inflation is one of the primary drivers of stock market returns.
Valuation Model Explained: If you want to get analysts really riled up, you need only to begin a discussion of market valuation. While the question of whether stocks are overvalued or undervalued appears to be a simple one, the subject is extremely complex. To simplify the subject dramatically, investors must first determine if they should focus on relative valuation (which include the current level of interest rates) or absolute valuation measures (the more traditional readings of Price/Earnings, Price/Dividend, and Price/Book Value). We believe that it is important to recognize that environments change. And as such, the market's focus and corresponding view of valuations are likely to change as well. Thus, we depend on our Valuation Models to help us keep our eye on the ball.
Wishing you green screens and all the best for a great day,
David D. Moenning
Disclosure: At the time of publication, Mr. Moenning held long positions in the following securities mentioned: none.
Note that positions may change at any time.
The opinions and forecasts expressed herein are those of Mr. David Moenning and may not actually come to pass. Mr. Moenning's opinions and viewpoints regarding the future of the markets should not be construed as recommendations. The analysis and information in this report is for informational purposes only. No part of the material presented in this report is intended as an investment recommendation or investment advice. Neither the information nor any opinion expressed constitutes a solicitation to purchase or sell securities or any investment program.
Any investment decisions must in all cases be made by the reader or by his or her investment adviser. Do NOT ever purchase any security without doing sufficient research. There is no guarantee that the investment objectives outlined will actually come to pass. All opinions expressed herein are subject to change without notice. Neither the editor, employees, nor any of their affiliates shall have any liability for any loss sustained by anyone who has relied on the information provided.
Mr. Moenning may at times have positions in the securities referred to and may make purchases or sales of these securities while publications are in circulation. Positions may change at any time.
The analysis provided is based on both technical and fundamental research and is provided "as is" without warranty of any kind, either expressed or implied. Although the information contained is derived from sources which are believed to be reliable, they cannot be guaranteed.
Investments in equities carry an inherent element of risk including the potential for significant loss of principal. Past performance is not an indication of future results.