Is Enough Baked In?
After a very scary decline and then an impressive rally, the question most investors are probably asking themselves is, where are we now?
In order to get our bearings, let's review where we've been. Recall that as of the market close on Christmas eve, the bears had pummeled the S&P 500 for a loss of -19.78% from the September 20th high water mark. Through December 13th, the decline had been orderly and fairly well contained. There were worries over this and that, but since the February/March lows had not been exceeded, a great many analysts (including yours truly, truth be told) were calling the action a garden-variety correction.
But then the bottom fell out. Over the next 7 sessions (one of which was a half-day), the S&P dove an eye-popping -11.3% as technical levels snapped like toothpicks, algos ran in high gear, and a bearish market environment took hold.
The thinking was the market was facing a triple threat of negatives that would surely end in the type of bear market cycle last seen in 2007-09 and 2000-02. It was a combination of fears over (1) the Fed overshooting again and pushing the economy into recession, (2) the trade war with China dragging on and sending the global economy into recession (or deeper into recession, depending on who you talk to), and (3) the simple fact that both earnings and economic growth were slowing both at home and abroad.
So, there it was. A bearish narrative that by late December became hard to argue with. This was going to end badly, we were told. Credit conditions were tightening - a lot as folks began to realize that a boatload of low-quality debt needed to be refinanced soon. The words contagion and systemic risk began making the rounds. Funds began to blow up. Forced sales started happening. Market models of all shapes, colors and sizes flashed red. And after a -15.74% drubbing in just 14 days between December 3rd and 24th, it certainly felt like the stock market was experiencing Déjà vu all over again and that the bad old days of the Financial Crisis had returned.
Instead of a run-of-the-mill correction, it now appeared that a bear, of the big, bad variety, was upon us. All hope was lost. To borrow a phrase from Mr. Jeff Macke, there were only two positions that mattered, cash and fetal.
A Funny Thing Happened On The Way To The Debacle
But just when it looked and felt like the world was about to end, one Kris Kringle showed up at the corner of Broad and Wall. Loaded with a sleigh full of toys - and some magic words from Jerome Powell - the Santa Claus rally began in earnest. Sure, Mr. Claus was a tad late. But when the U.S. and China started talking turkey about a deal, the mood suddenly changed, and the traditional Santa Claus rally ripped higher.
Fast forward to today. Suddenly, investors find themselves with a rally that has propelled the S&P 500 up +10.43% in just 12 days. Suddenly, one of the three big threats has been solved (the Fed looks to be on hold) and another appears to be on its way to being, at the very least, mitigated (i.e. it looks like the trade war will get solved). And given that valuations are suddenly a lot better than they were even a few months ago, some folks are arguing that the third big threat (slowing growth) is already baked into the cake.
#GrowthSlowing - Is Enough Baked In?
Let's think this through. The S&P fell almost 20% on the back of the three big worries. Two of those worries appear to be handled. As a result, the S&P is now off -11.41% from its peak. So, the question becomes, is a drop of 11.4% enough to account for the slowdown in earnings that everyone is expecting?
To be sure, earnings expectations are heading lower - and at a rapid rate. Here's a chart of calendar-year EPS estimates over time that makes this point clear...
View Chart Online
Source: Ned Davis Research
Note the steep decline in the salmon colored line (which represents EPS estimates for 2019) in the upper right. The only other time estimates dove this fast was back in 2015 (and to a lesser degree, in 2016) as the oil crash took its toll on earnings.
So, as we enter earnings season, the key question is if earnings estimates have been knocked down enough to reflect the reality of slowing global growth. Currently it looks like EPS estimates for full-year 2019 is down about $6.00 (approximately 3.4%) from the levels that were being projected back in the fall.
According to FactSet, EPS for the upcoming earnings parade (Q4 2018) is currently expected to grow by 10.6% on a year-over-year comparison basis. It is worth noting that a 10.6% gain would represent a 5th consecutive quarter of double-digit earnings growth. So, this is where the earnings "bar" is currently set.
From my perch, unless Powell & Co. change course again or trade negotiations break down completely, earnings will now become the key focus. As such, the always fun game of reality versus expectations during earnings season is likely to control the action in the near-term.
While I run the risk of earning a Captain Obvious tag here, guidance and management commentary is going to be critical during the upcoming earnings parade. Rest assured that you are going to hear the words, China, slowdown, wage pressures, and increasing costs a lot. From my seat, it is the degree to which these words are used and the overall tone of forward guidance that will tell us whether current prices in the stock market are too high, too low, or about right. We shall see.
Weekly Market Model Review
Now let's turn to the weekly review of my favorite indicators and market models...
The State of the Big-Picture Market Models
I like to start each week with a review of the state of my favorite big-picture market models, which are designed to help me determine which team is in control of the primary trend.
View My Favorite Market Models Online
The Bottom Line:
- For the third week in a row, there are important changes on the Primary Cycle board. And for the second week in a row, the changes are to the upside. First, the "State of the Market" Model flashed buy signal. Ditto for my "Desert Island" Model and the Environment model. And in each case, the model reading improved. While it is nice to see some Buy signals back on the board, the bulls still have some work to do in order to get the model readings up into the positive zone.
This week's mean percentage score of my 6 favorite models improved to 46.1% from 40.3% (2 weeks ago: 36.5%, 3 weeks ago: 41.9%, 4 weeks ago: 47.8%) while the median rose to 55.0% from 50.0% (2 weeks ago: 44.0%, 3 weeks ago: 44.2%, 4 weeks ago: 45%).
The State of the Trend
Once I've reviewed the big picture, I then turn to 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.
View Trend Indicator Board Online
The Bottom Line:
- The bears contend that the stock market is in the midst of a classic dead-cat bounce. However, the bulls counter with the idea that one of the three negative drivers of the market action has been resolved (the fear of a Fed overshoot), one is in the process of being resolved (the trade war with China), and the third (slowing growth) has already been "baked in" to current prices. In my opinion, how the S&P 500 acts given the important overhead resistance and the start of the earnings season will likely settle the argument.
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.
View Momentum Indicator Board Online
The Bottom Line:
- The message from the Momentum board is that from a short-term perspective, the action has been quite strong. But from an intermediate-term standpoint, there is still a lot of work to be done to repair the technical damage. The good news is that we have seen some "breadth thrust" signals lately, which is something that was lacking during the April-September 2018 rally. This suggests that once the testing/basing process is completed, a new upleg in the ongoing secular bull is likely to emerge.
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.
View Early Warning Indicator Board Online
The Bottom Line:
- The positive tailwinds from the shorter-term oversold, mean reversion, and VIX indicators have now been worked off and are all now very close to the levels that tell us it is "time to go the other way." However, the good news is the intermediate-term indicators as well as the sentiment readings all continue to favor the bulls.
The State of the Macro Picture
Now let's move on to the market's "environmental factors" - the indicators designed to tell us the state of the big-picture market drivers including monetary conditions, the economy, inflation, and valuations.
View Environment Indicator Board Online
The Bottom Line:
- There continues to be improvement in our External Factors board. Last week, I reported that the monetary composite had upticked in response to the pullback in rates and that the inflation model was now solidly green. This week, it is important to note the improvement in the Valuation Composite, where the signal moved from sell to hold and the rating improved to neutral from negative. For me, the message here is clear: While valuations are clearly not a tailwind for the bulls, they are also no longer a strong headwind.
Thought For The Day:
If everyone is thinking alike, then someone isn't thinking. - General George S. Patton
Wishing you green screens and all the best for a great day,
David D. Moenning
Founder, Chief Investment Officer
Heritage Capital Research
HCR Focuses on a Risk-Managed Approach to Investing
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HCR Awarded Top Honors in 2018 NAAIM Shark Tank Portfolio Strategy Competition
Each year, NAAIM (National Association of Active Investment Managers) hosts a competition to identify the best actively managed investment strategies. In April, HCR's Dave Moenning took home first place for his flagship risk management strategy.
At the time of publication, Mr. Moenning held long positions in the following securities mentioned: None - Note that positions may change at any time.
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.
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 -12.29% 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.
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.