In a previous article, I outlined both the purpose and construction of the Simple Stock Model. Keep reading for a quick run-down if you're new to the model, otherwise you can skip down to "Technicals" for the updated data.
Investors are constantly exposed to sound bites and data points presented without any proper context. You might have read an article about how stocks have historically bounced when sentiment has reached a negative extreme. Or that you should be out of the market if it's trading below its 200-day moving average. When I come across articles like that, I always thought it was short sighted to base an opinion on the S&P on only one indicator without also considering a wide variety of other inputs.
The goal of the model is to help you form a data-based outlook on the S&P. Additionally, at the end of this article, I showcase a composite model that incorporates all of the indicators I use so your view can be comprehensive, as opposed to having tunnel vision on only one indicator.
How the Model Works
Each article is broken down into four main sections: technicals, sentiment, rates, and macro. Each section includes a number of different indicators. For each indicator, there's a "filter rule" for when to be out of the market. In the spirit of simplicity, the filter rule is always binary, dictating either 100% long exposure to the S&P or a 100% cash position. The S&P is represented by the SPDR S&P 500 Trust ETF (NYSEARCA:SPY). Let's dive into an example graph.
The above graph is of the price momentum indicator within the technicals section. The bottom portion plots the momentum metric over time and the top portion plots the historical performance of following the filter rule.
For each indicator, new data each weekend is used to generate a long SPY or cash position for the next week. For the above momentum example, SPY's dividend-adjusted close as of Friday is the main input. Using this, I calculate the 12-month total return. For each indicator on this site (except for the macro data), I take a 4-week average of the main indicator input. So for this example, I'm taking the 4-week average of 12-month total return momentum. Why four weeks? To reduce false positives and whipsaws when an indicator is bouncing slightly above or below its filter rule. There's nothing special about a 4-week average. You could use two or eight weeks and reach similar results.
Data is compiled as of Friday's close. Buying or selling decisions occur on Monday's close. I do this, as opposed to making trades at Monday's open, simply because I had a more reliable data source for dividend-adjusted close data. It's also important to reflect realistic transaction costs. Each historical performance graph factors in a $10 trade commission and a 0.02% spread on SPY for each buy or sell. Commissions and spreads are lower now, but considering SPY started in 1993, I chose to use these above-average numbers.
Now you understand the methodology behind the model. Each week I'll cover a handful of indicators, especially those that have changed positioning over the past week. So let's get started with some technicals.
Price momentum is starting to turn north.
We just exited the buyback blackout period. Corporations have to suspend buybacks prior to announcing earnings. Now that most companies have reported Q2 numbers, share repurchase programs are back in full force.
We're outside of the historically positive pre-FOMC window. The window is specified as being 20 trading days prior to a FOMC meeting date. This strategy has resulted in being in the market only 2/3 of the time since 1993, yet has matched buy and hold returns.
The AAII survey has yet to reflect excess optimism in the market.
The NAAIM Exposure Index paints a different picture. Active managers are very bullish on U.S. stocks.
CBOE's total put/call ratio is fairly low, reflecting increased complacency in the option markets.
High yield spreads (NYSEARCA:JNK) are below their long-term trend.
The yield curve has flattened significantly in 2016. To analyze the yield curve, I look at how the spread between the 10-year (NYSEARCA:IEF) yield and 2-year (NYSEARCA:SHY) yield has changed over the past twelve months.
Last week's ISM PMI number came in a bit below expectations at 52.6.
Friday's unemployment rate of 4.9% is still below the long-term trend, a historically positive sign for future short-term stock returns.
S&P earnings are down over the past year.
So that wraps up the weekly update on some of the individual indicators. Now, for the composite model.
Think of each indicator as a building block that helps form an overall opinion. One study might say current sentiment has historically been bullish for stocks. Who cares, that's just one data point in isolation. I'm interested in a bigger picture view with more context. A picture that also factors in what's going on with macro data, interest rates, etc. The composite model does just that.
Here's how it works: each indicator is given a score of 1 or 0 depending on its current reading relative to its filter rule. If S&P earnings are down over the past year and the filter rule for that metric is to be out of the market if yearly earnings growth is below 0%, then that indicator gets a 0. The table below summarizes data from all the previous sections and assigns a 1 or 0 to each indicator based on its current reading.
For each category of indicators (technicals, macro, etc.), an average is calculated. Currently, the average score for technicals is 0.6. All four category average scores are then averaged to form the composite score. If the composite score is greater than 0.6, the model is invested in SPY. Think of 0.6 as the overall filter rule for the composite model. There's nothing special about 0.6. It results in being invested in SPY about 2/3 of the time. I could have used a higher filter rule like 0.75 to only be exposed to the S&P when more indicators are saying to be invested, but this results in less time exposed to the market since it's a "stricter" cut-off. The charts below plot each individual category average score and the overall composite score.
So where do we stand? Price momentum and trend are strong, although we are in a seasonally weak period plus we're outside of the positive pre-FOMC drift window. Some sentiment indicators like the high NAAIM Exposure Index and low CBOE total put/call ratio are cause for concern. The yield curve is flattening and high yield spreads are contracting, both positive signs. Finally, macro data is strong, with the exception of weak industrial production and weak S&P EPS growth.
Overall, the composite model is still invested since the composite score is 0.72, above the cut-off filter of 0.60. I hope this article can help you out in your own investing endeavors. Do let me know if you've got any questions in the comments below!
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: The information in this article is for personal use only. Investing involves a great deal of risk, including the loss of all or a portion of your investment. Nothing in this article should be construed as a warranty of investment results. All risks, losses and costs associated with investing, including total loss of principal, are your responsibility.