My Current View Of The S&P 500 Index - February 2017 Edition

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Includes: AGG, BXUB, BXUC, EFA, EPS, IVV, LLSP, RSP, RWL, RYARX, SDS, SFLA, SH, SPDN, SPLX, SPUU, SPXE, SPXL, SPXN, SPXS, SPXT, SPXU, SPXV, SPY, SSO, TALL, UPRO, VFINX, VOO
by: Walter Zelezniak Jr

Summary

EFA outperformed for the month of February.

My trading system is reviewed.

A sell signal in AGG.

The month of January proved to be another profitable month for my retirement plan. I began the month by being invested in the S&P 500 Index ETF (NYSEARCA:SPY), the Russell 2000 Index ETF (NYSEARCA:IWM) and the iShares Core U.S. Aggregate Bond ETF (NYSEARCA:AGG). Those positions returned 1.79%, 0.28%, and 0.21% respectively. I began the month being allocated 40% to SPY, 50% to IWM, and 10% to AGG. Consequently, my return for the month works out to be 0.87%. See Table 1 below.

Table 1 - January, 2017 Monthly Returns

Position

ETF Return

Allocation

My Return

SPY

1.78%

40%

0.71%

IWM

0.28%

50%

0.14%

EFA

3.29%

0%

0.00%

AGG

0.21%

10%

0.02%

Cash

Total

100%

0.87%

How did I end up being invested in SPY, IWM and AGG? I was invested in each ETF because they were all in bullish alignment according to my trading system. In my trading system bullish alignment means that the 6 month exponential moving average is higher than the 10 month exponential moving average. Price is above both moving averages. While not a perfect system, this setup is considered bullish and I expect price to move higher long term. The opposite of a bullish alignment is of course a bearish alignment. This is when price is below the 6 month moving average which is below the 10 month moving average. When this alignment is present I expect price to decline over the long term. Chart 1 below shows my trading system over a 20 year period using the S&P 500 index.

Chart 1 - S&P 500 Monthly Price Chart with 6/10 Exponential Moving Averages

Chart 1 shows that the trading system went into bearish alignment in late 2000 and again in early 2008. While these two trading signals did not occur at the peak of the market, they did occur in plenty of time to allow investors to cash out and head for the sidelines before real damage could be done to their retirement accounts. That is what appeals to me about this system. This trading system keeps me out of danger. I am primarily concerned with capital preservation. After capital preservation comes outperforming the S&P 500 index on my investment wish list. I believe that by avoiding the big drawdowns such as the ones that occurred in 2000 to early 2003, and 2008 to early 2009, I can outperform the S&P 500 index over the long term.

As for entering the market the trading system did signal investors to get back into the market in the second half of 2003 and in the second half of 2009. Similarly to the bearish trading signal discussed earlier, the bullish trading signal did not occur at the bottom of the market but it did occur in plenty of time to allow investors to capture the long term multi-year gains that followed each bear market.

To me the biggest negative of the trading system is the whipsaw. This is when the ETF moves sideways in a consolidation pattern over a period of months and a bearish signal is quickly followed by a bullish signal or vice versa. In Chart 1 you can see that whipsaws happened in late 2015 and in early 2016. Whipsaws can also be seen in Chart 3 below. To my knowledge there is no perfect trading system or methodology as they all have their drawbacks. Whipsaws are the drawbacks of this trading system.

The second part of my trading system is using relative strength to determine which ETF is outperforming the others. I want to ensure that the majority of my money is allocated to the asset that is performing the best over the long term. Consider Table 1 again. The iShares MSCI EAFE ETF (NYSEARCA:EFA) outperformed all others in January and returned an outstanding 3.29%. However, I was not in EFA. The reason I was not invested was because of EFA having poor relative strength compared to SPY and IWM. See Chart 2 below.

Chart 2 - Relative Strength EFA:SP 500 Index

The falling line indicates that EFA is underperforming the S&P 500 index. This has been going on for several years. Yes there are a couple of months that EFA outperformed the S&P 500 index, but for the most part that hasn't been the case. Investors would have been better off investing in American stocks compared to EFA for the last several years. This is true even if EFA is in bullish alignment as can be seen in Chart 3. There is one caveat to relative strength. Index A can have relative strength compared to Index B and an investor can still lose money investing in Index A. That because Index A could lose 1% for the month while Index B loses 2% for the same month. On an Index A:Index B relative strength chart the line would be rising because Index A outperformed Index B by losing less money. In this case that would mean that an investor would just be losing less money investing in Index A compared to an investor in Index B.

Chart 3 - EFA Monthly Price Chart with 6/10 Exponential Moving Averages

Charts 4 and 5 show the ETFs SPY and IWM respectively. Both ETFs have been in multi-month bull moves. SPY hit a new high in January while IWM mostly consolidated its recent gains.

Chart 4 - SPY Monthly Price Chart with 6/10 Exponential Moving Averages

Chart 5 - IWM Monthly Price Chart with 6/10 Exponential Moving Averages

The one change in allocation this month is due to the bearish signal that occurred in AGG. See Chart 6 below. While it just barely happened a sell signal was generated as the 6 month exponential moving average did close below the 10 month exponential moving average. Consequently, I closed that position.

Chart 6 - AGG Monthly Price Chart with 6/10 Exponential Moving Averages

For the month of February I am allocated 60% to IWM and 40% to SPY. Chart 7 below shows the relative strength of IWM to SPY.

Chart 7 - Relative Strength IWM:SPY Index

IWM has outperformed SPY since the beginning of the year. A strong dollar, expectations of a growing economy, the promise of tax cuts, and reductions in business regulations by the new Trump administration could all be factors for small capitalization stocks to be outperforming large capitalization stocks. However, I don't have to think much about that. My trading system is designed to simply follow the long term trend of the market and allocate my money to the best performing asset among SPY, IWM, EFA, AGG, and cash. Currently that system has me allocated 60% IWM and 40% SPY. When February is over, I will again look at the charts and react accordingly. It is simply a matter of planning my trades and trading my plan.

Disclosure: I am/we are long IWM, SPY.

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.

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