Don't Fight The Tape

by: AAJJ Investment Research


'Don't fight the tape' is advice that would have been useful since November 8, 2016.

Most investors don't know how to interpret the tape correctly.

The tape says investors should continue to favour risky assets, but watch out for growing signs of exuberance.

'Don't fight the tape' is an expression many investors are familiar with and one that has been particularly useful since November 8th. However, most investors I've met, heard or read from only have a superficial understanding of how to interpret the 'tape' - particularly as they tend to analyze, or indeed over-analyze, one market or chart at a time without checking if other markets confirm or conflict with their findings. In this article, I will review price action from different markets to determine how I believe investors should position themselves for the months ahead.

Small-caps, high yield foreign stocks have led, and confirmed, this large cap rally

When the S&P 500 moves higher, it's good to see small caps (NYSEARCA:IWM) outperform large caps (NYSEARCA:SPY) and for high yield (NYSEARCA:HYG) to outperform treasuries (NYSEARCA:IEF) and investment grade corporate bonds (NYSEARCA:LQD). The implications of such outperformance are clear: for small caps and high yield to perform well, investors must have a positive economic outlook since smaller business and less creditworthy borrowers need a growing economy to thrive - or indeed survive.

Of course, there are times when the broader market indices rise even though small-caps and high yield perform poorly. However, sharp pull-backs in the broader market tend to occur soon after these 'divergences' start to appear. Again, it's easy to understand why: if small-caps and high yield perform poorly, it is likely that investors expect the broader economy to weaken - if things deteriorate badly enough, investor sentiment will also turn negative for the larger companies.

In addition to small-caps and high yield, it is reassuring to see ex-US stocks (NYSEARCA:VEU) do well at the same time as US stocks. Since the US economy does not exist in a vacuum, weakness in ex-US stocks is a bad sign since it probably implies that investors anticipate weak economic growth outside the US. In addition to analysing price action of ex-US stocks in isolation, I find it helpful to analyse relative strength charts of ex-US stocks versus 10-year US treasury prices (NYSEARCA:UST).

We can see from the charts below that there are solid upward trends for the outperformance of high yield versus investment grade corporate bonds, small-caps versus large-caps, and ex-US stocks versus 10-year US treasuries. As long as these charts remain above their blue lines (40-week exponential moving averages), we can say that risk appetite is consistently strong across several markets and, thus, remain fairly comfortable with risk assets.

Of course, these charts are not meant perfect timing tools - no such tool exists. Nevertheless, reviewing these relationships at the same time can be a very helpful step in one's investment process. Moreover, if you look closely at the late 2015/early 2016 period, you will see that these charts gave plenty of warning before the big drops that caught so many strategists and investors by surprise.

Broad participation adds further credibility to the rally

Market breadth is an important topic for technicians seeking to gauge the strength of a rally in the broader indices and their likely future direction. There are several indicators that demonstrate market breadth and most of them are suggesting that this rally has received, and continues to receive, broad support.

The two charts below show that 69.77% of the NYSE Composite's constituents and 80% of the S&P 500's constituents are currently above their 200-day moving averages. It's a good sign if these measures rise consistently with the broader indices and make higher highs. However, it's concerning when these measures rise to or above extreme levels (e.g. typically 85%) or fall below historically key levels like the 45% line. At the moment, we can say that there is healthy participation in the market's post-election rally given that c. 70% of US stocks are technically in an upward trend.

Another measure I like to look at is the S&P 500 Equal Weighted Index and its relative strength versus the market-cap weighted S&P 500. When the former breaks its upward trend, or when it starts to underperform the latter, we have a signal that breadth is weakening.

In the below chart, we can see a clear divergence: the S&P 500 (green line) continues to move higher but the relative strength chart has fallen below its 40-week exponential moving average (i.e. it is entering a downward trend). If the relative strength chart makes lower lows below this moving average and the equally-weighted index also breaks its upward trend, I will become concerned for the health of the broader market's rally.

Signs of 'peak exuberance' are starting to show

So far, most of the signals I've shared suggest that risk appetite is strong. However, there are also signs from certain markets that suggest this healthy appetite for risk is turning into overzealous euphoria.

The first example of exuberance comes from the high yield market in the form of high yield credit spreads. Since peaking at almost 9% in early 2016, high yield spreads have been tightening as investors priced in a less aggressive tightening cycle than first anticipated and a recovery in commodity prices. However, it is very unusual to see high yield spreads below 4%. Also, they don't stay that tight for very long. When spreads fall below 4%, it is likely that credit investors are overly optimistic and further gains become increasingly unlikely.

The second example comes from a relative strength chart of the S&P 500 versus 10-year US treasury bond prices. The possible evidence of euphoria comes from the fact that this chart is strongly overbought based on weekly RSI (75.95). We've only seen such extreme levels four times in the past eight years. Each occasion was followed by a pull-back in the S&P 500, including a particularly sharp correction in 2011. Although it's impossible to predict how sharp of a correction we could have, or if we will have one at all, it is clear that the risk appetite pendulum has swung in favor of risk after reaching the other extreme in early 2016. A swing back towards safety is therefore entirely plausible.

Conclusions - keep an overweight to risk assets until the tape says otherwise

Another one of my all-time favorite quotes on investing comes courtesy of Benjamin Graham:

In the short run, the market is a voting machine but in the long run, it is a weighing machine.

There are plenty of excellent articles arguing that equity markets are currently overvalued. Much the evidence presented is, in my opinion, compelling. However, the voting machine is currently at odds with the weighing machine's valuation tools given that market participants continue to 'vote' for higher prices in risky assets.

Many readers may say that the measures I've used are simplistic or even crude. However, I believe that investors should take price action seriously, especially when there are confirmatory signals across several markets (e.g. equities, credit, treasuries, commodities, etc.). After all, price action represents where investors are actually putting their money. Conviction drives capital allocation, and conviction itself is driven, at least initially, by thorough analysis of the facts and probabilities. This brings me to the third quote of the article, courtesy of Warren Buffett:

First come the innovators, who see opportunities and create genuine value. Then come the imitators, who copy what the innovators have done. Sometimes they improve on the original idea; often they tarnish it. Last come the idiots, whose avarice undermines the innovations they are trying to exploit.

I believe that studying price action properly helps us follow the first movers, or 'innovators,' who tend to anticipate transitions within the market cycle and allocate capital accordingly. Although the 'tape' is suggesting that it is too early to shun risk assets entirely, a more in-depth study of price action also reveals a few signs of 'peak exuberance.' The trickiest part is that everyone tries to head for the exits at the same time, so we need to be extra vigilant at times like this and look out for the moment when the tape tells us that the 'idiots' have taken over!

Acknowledgement: most of the ideas from this article are from the excellent work of the legendary John Murphy, particularly his book "Trading with Intermarket Analysis."

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.