The MMI Are Bearish as Liquidity Has Dried Up and September Has Arrived - Caution Is In Order
In the wildly popular TV show Game of Thrones, various characters keep reminding us "winter is coming" (devoted show fans know that winter has indeed arrived in Westeros). For investors we suppose the comparable phrase is "September is coming". Well, September has arrived, and as you are reading this Labor Day is in the rear view mirror. September is statistically the worst performing month on the calendar. We enter it with a string of bearish MMI readings leading into it. Given this string of bearish readings we recommend investors take protective measures.
Our weekly calculation of the Major Market Indicators scores bearish this week. This week's bearish score represents the fifth out of the past six weeks the indicators have scored bearish. This week, the MMI ended at 49.67 as shown in the chart above, and the graph below. We require a score of at least 60.00 to warrant a bullish rating, while any score below 50.00 is bearish.
A key reason for the bearish reading this week is the liquidity indicators, which are bearish this week. We calculate trailing four-week cash flows into/out of the market (see details further below) and this calculation has a tendency to run hot and cold. In late June we saw huge stock buyback announcements from the big banks supervised by the Federal Reserve. Since then, buybacks have slowed down considerably, as has M&A activity. August is a vacation month, and Wall Street bankers took their vacations. Up until this past week mutual fund and ETF cash flows have been negative. Further below we detail the calculation in full.
Looking forward, liquidity should improve as M&A normally picks up after the August doldrums. GDP was strong in the most recent report on Q2:17, +3.0% in real terms, but we wonder if the effects of Hurricane Harvey on the fourth largest city in the county won't shave a bit off growth in Q3:17. Further, we wonder if the continual speculation over "a bear market's got to come sooner or later" may become a self-fulfilling prophesy.
The S&P 500 has experienced a series of peaks and valleys since early last year. It's worth noting that the index moved sideways despite a series of ups and downs, from October 2014 to February 2016, but since the bottom in mid-February 2016 the market has risen strongly, with just a 5% pullback which ended early November last year. This past month all the major indexes hit new peak levels. Investors may wish to view the chart below as recommending an active trading strategy.
The chart below shows the performance of the major indexes since their highs, as well as year to date. This has been a good year for stock investors so far. Our recommendation above for protective portfolio measures is based on the signal supplied by the MMI as well as the common sense attitude that markets don't go up in a straight line forever.
Below, the weekly graph of our Major Market Indicators shows the trend since December of 2014 through September 3, 2017.
The MMI is a collection of at least 46 different indicators (some have sub-indicators) covering the categories shown in the chart above, which try to "take the temperature" of conditions for equity investors. Frequently investing pundits try to point to a single statistic as justification for bullishness or bearishness. The MMI is designed to take a broad reading of the data to achieve a more measured response. We've been publishing our results since May of 2014 as shown in the graph above.
This is the stock market that just does not quit. Optimism for growth has taken hold, and bad news does not seem to "stick". Call it the Teflon Market? The list of worries to concern investors is long, beginning with the realization the Federal Reserve has indeed begun a tightening cycle (and don't those usually end badly?). Investors will react emotionally to events as they unfold (don't we always?), and that's where the MMI analysis comes in. The MMI index is an approach designed to take some of the emotion out of the process and take the measure of what the markets are telling us. Right now the markets are telling us the backdrop to investing is bearish. While many investors are nervous in that the market has made so much progress since the election, the MMI index is saying the weight of the indicators is not supportive of further gains.
Please read on below for the details of how we arrive at our MMI index calculation.
Market Sentiment Indicators: Bearish
The market sentiment indicators score bearish this past week, with nine indicator points out of twelve bearish and three bullish. Since we use a mostly contrarian judgment on sentiment, a bullish behavior by market participants registers as bearish, and vice versa.
In terms of bearish indicators, the Volatility indicators (VIX and VXN) stood at week's end at 10.13 and 14.10. We require both of these indicators to sit above 20.00. Implied volatility, when it has risen, has come back down rather quickly over the past few years as evidenced by the graph below. We remain awed, as you probably are, by how low volatility has reigned supreme for so long. This indicator scores one point bearish. The Put-Call ratio on the S&P 100 ended the week at 99/100, and since we require this to be over a benchmark of 125/100 to score bullish, this produces one indicator point bearish. The Put-Call ratio on the CBOE ended the week at 57/100, and since we require this to be over a benchmark of 60/100 to score bullish, this produces one indicator point bearish. The ARMS index on the NYSE and NASDAQ (0.69 and 1.23 respectively) were bearish, since they were below our benchmark of 1.50 for bullishness. That's two points bearish.
The confidence index, the ratio of the index of high-grade bonds yield vs. intermediate grade bonds yield (3.06%/3.98%) produces a ratio of 76.9%; we score any spread over 75.0% as bearish. That's one point bearish. Next, the TIM Group Market Sentiment Indicator (52.50%) ended the week with a reading above 50.00%, and thus we score it one point bearish. Finally, the Consensus Index (73%) and the Market Vane Index (66%) were both above a 50.00% reading, and thus we score these as two points bearish. So that's nine indicator points scoring to the bearish.
On the bullish side of the ledger, the AAII (American Association of Individual Investors) survey of investors registered a ratio of bullish to bearish attitudes of 0.63, and since a ratio below 1.00 shows a tendency for individual investors to lean slightly to the bearish, we score this as a bullish reading (the contrarian viewpoint again). That's another one point bullish. Finally, the short ratio on both the NYSE and the NASDAQ (as of the last reading, August 15 th) were bullish, at 5.10 days and 4.18 days to cover for both these markets, respectively, which is two points bullish. This adds up to three bullish indicator points.
The volatility chart below, though August 31 st, graphically depicts what many observers have been saying about this market: where's the volatility? Is sure looks like it's compressing like a spring, waiting to bounce up. Our question is when? We have not had an even 5% pullback in the S&P 500 since last year.
The chart below indicates sentiment is neutral. Citigroup's assessment of investor sentiment along the panic/euphoria axis is wavering between the panic and euphoria range, with no clear direction.
To summarize, nine points scored bearish and three bullish, thus the market sentiment category scores bearish for the week.
Technical Indicators: Bullish
With the major indexes all hitting all-time highs this week, it's no surprise our technical indicators scored bullish, with 11 of 15 indicator points bullish this week.
On the bullish side of the technical indicators, we scored six bullish points from the indexes we track. We score specific indexes vs. their 200 day moving average at the week's end. Since these indexes are above their respective 200 day moving average, they all score bullish. The indexes we score were above their 200 day moving average at the end of this past week, by the following percentages: The S&P 500 by +4.83%, the Dow Jones Industrial Average by +5.98%, the NASDAQ composite by +8.67%, the NYSE Composite by +3.67%, and the Guggenheim S&P 500 equal weight ETF (RSP) by +3.24%. In our methodology, we double weight the equal weight ETF (RSP) and the equal weight ETF (EWSC), so they both score either a 0 or a 2 (the EWSC was bearish this week). Thus the indexes generated six points to the bullish.
Additionally, the ratio of new highs to new lows at the end of this past week was 2.37x, and since this is above our benchmark of a 2:1 ratio, this is one point bullish. The advance/decline weekly volume ratio on the NYSE was 1.42 and on the NASDAQ it was 1.82. Since we require a score for these ratios of over 1.12 to rate as bullish, these volume ratios score two bullish points. We score the advance/decline ratio of the number of stock issues rising vs. falling. The NYSE achieved a ratio of 2.55, and the NASDAQ registered a ratio of 2.25. We require a ratio of greater than 2.00 to score bullish, so these metrics together generate two bullish points. Thus the total number of bullish indicator points adds up to eleven.
Four of a possible 15 points in our technical score were bearish. The Guggenheim S&P Small-Cap 600 equal weight ETF (EWSC) was below its 200 day moving average at week's end by +0.87%, so that accounts for two bearish points all by itself. Also, we score the 10 day moving average of up vs. down volume on the NYSE and the NASDAQ, and this produced two more bearish readings. The 10-day moving average of the NYSE registered at 1.31 and the 10-day moving average of the NASDAQ was 1.45. The required ratio for a bullish score is 1.50, so this metric produced another two bearish points. That's a total of four bearish indicator points.
Thus we have a total of eleven indicator points bullish and four indicator points bearish. Therefore we rate the technical indicators as bullish overall.
Liquidity Indicators: Bearish
Our liquidity indicators are neutral this week. Money market funds balances are 9.81% of the market cap of equities, which provides buying power to support stock prices, a bearish score, since we require a ratio of money market fund balances greater than 10.0% of market cap in order for this indicator to score bullish. Customer credit balances at brokerages stood at only 27.6% of margin debt at last reading, a low level and a bearish score. In a sharp sell-off, customers either have to post more cash to bring their margin account above the minimum maintenance threshold, or margined stocks will be sold to meet the cash call. This low cash level implies increased risk of customers having to meet margin calls with stock sales rather than posting more cash. So that's one bullish and one bearish reading.
An additional bearish indicator was our cumulative market liquidity calculation for the trailing four weeks. We collect net cash flow data in a number of categories and score the net total as bullish or bearish. Total flows into the market as calculated are registering a bearish inflow as of the end of this past week.
Mutual funds (including ETFs) have seen net outflows over the past four weeks, with a net ($6.0) billion withdrawn from the market for the four weeks. Interestingly, net flows to ETFs over the four weeks was positive, while more than 100% of the outflow can be attributed to outflows from traditional mutual funds. This in part may be a result of the continued movement of investors to indexing their money, and ETFs are a convenient mechanism to accomplish that.
In the corporate acquisition market we count only the cash component of M&A deals as announced. The sum of that figure for these four weeks was $21.1 billion. The largest contributors to this figure were the following deals: Gilead Sciences (GILD) announced the acquisition of Kite Pharma, Inc. (KITE) with a $11.9 billion cash component, and Equity Capital Partners (a private company) buying Calpine Corporation (CPN) with a $5.6 billion cash component. We treat M&A deals announced as a positive source of liquidity.
Announced stock buybacks also are treated as a positive source of liquidity, and they contributed another $13.5 billion to our liquidity calculation in terms of total buyback authorizations announced in the trailing four weeks. We capture the cash value of prospective buybacks at the time of the announcement. Public companies typically make their buyback announcements at the time of or shortly after their earnings announcements. We find it notable that buyback announcements following second quarter earnings were significantly lower in total volume than we had seen in prior quarters.
IPO activity is still pretty dismal, though it will likely exceed 2016's level, a healthy sign. We capture the total value of new market capitalization added to the market. The past four weeks saw only $1.9 billion of new market capitalization added via the IPO market. There were no large IPOs in the past four weeks. We treat IPO activity as a reduction of liquidity.
The chart below shows the number of issues which successfully priced their IPOs over the past decade, with 2017 showing YTD numbers. 2017 looks to be on track to beat 2016 with four months remaining in the year.
Source: Renaissance Capital, Singular Research
Secondary stocks offerings are also treated as a reduction of liquidity, and constituted $6.7 billion of cash offerings in the trailing four weeks. While we count the total value of shares sold in secondary offerings, we exclude sales by large existing shareholders (such as private equity) which do not increase the total number of shares outstanding. Only new shares are captured in this calculation. The largest deal we counted in our calculation was priced by Thermo Fisher Scientific (TMO), which sold common stock with a total value of $1.5 billion.
We make a separate calculation of the value of shares sold by CEOs and other corporate insiders. Insider selling pulled $8.35 billion of net cash out of the equity markets in the past four weeks, and this is treated as a reduction of liquidity.
We track cash inflows to domestically focused equity hedge funds on a monthly basis. We calculate cash outflows to domestically focused equity hedge funds at approximately $2.5 billion in July (August data is not yet available). Given the relative secrecy of hedge funds this calculation will always be a rough approximation, but we are applying our methodology on a consistent basis, month-to-month.
Overall, we count up a positive net inflow of liquidity into the domestic market of approximately $9.2 billion for the past four weeks, which is less than sufficient to warrant a bullish score. We require at least $20.0 billion of calculated positive liquidity to warrant a bullish score, so therefore the liquidity calculation this week is clearly bearish. We double weight this calculation in our MMI scoring, so this calculation above produces two points bearish. Combined with the other factors above we score liquidity as bearish, as zero out of a potential four points scored bullish.
Valuation Indicators: Bullish
Our valuation indicators score at a bullish level this week. Our fair value target for the S&P 500 is 3312, representing a 33.7% upside from the close on September 1 st. That upside potential is a bullish indicator in our calculation. We require a potential upside of at least 10% to score it bullish. The target uses a 25.1x multiple applied to 2017's estimated operating earnings of 131.80. Our fair value target multiple is arrived at using an intermediate grade bond yield rather than the ten year Treasury bond, due to the artificiality we are still experiencing in the aftermath of Quantitative Easing. The S&P 500 is trading at 19.6 times the trailing four quarters operating earnings (through the second quarter of 2017), compared to an historical norm of 15.5 times operating earnings. The S&P 500 is now trading at 18.8x 2017E and 17.0x 2018E earnings per share, respectively.
We score the target for the S&P 500 a second time, with a more conservative price target, using a discounted P/E multiple at 90% from the prior target. We require a minimum of a 10% upside from the current index price to this second target in order to score the indicator as bullish. The calculation produces a prospective gain vs. the week's close of 20.3%. Since this is more than a 10% potential gain, it scores bullish. To calculate this, we multiply the fair value P/E times the EPS projection times 90%, and compare it to the most recent closing price of the S&P 500. Thus we recognize two points bullish on our fair value targets.
We score small cap stocks, as judged by comparing the P/E of the T Rowe Price New Horizons Fund to the P/E of the S&P 500. This ratio, at 1.498 times, is just barely less than our benchmark of 1.50x necessary to justify scoring it bullish, so therefore it is one point bullish. We note this is implicitly saying that small cap stocks are cheap relative to large caps.
Compared to GDP the market (using Wilshire's total market value-Full Cap) is at a 44% premium. Since this is more than our benchmark of a 25% premium to GDP, we score this one point bearish.
There are a couple more bullish indicators. We estimate the total domestic market capitalization is trading at 92.8% of replacement cost of the asset base of non-farm, non-financial corporate businesses. By this metric, our version of Tobin's q, stocks are cheap. Since this is less than 100% of replacement cost we score this indicator as one point bullish. Finally, we divide the earnings yield of the S&P 500 by the Merrill Lynch corporate BBB effective bond yield. The resultant ratio, 1.18x, is greater than one, and thus it is bullish.
Overall, with valuation indicators scoring five bullish and one bearish indicator points (out of a possible six points), we rate the overall category as bullish.
Earnings Momentum Indicators: Bullish
We score this category of indicators measuring earnings momentum. The momentum as we measure it is currently Bullish.
The earnings season for the second quarter 2017 is essentially over. The S&P companies have reported a positive to negative ratio of earnings surprises at 3.49x, a bullish score (we set a high bar for this indicator; since the earnings game system is set up to naturally encourage companies to "beat the Street" we require a ratio of greater than 3.0:1 for this indicator to score bullish). We double count this indicator since it's such a key component of earnings momentum, and it scores two points bullish.
We score earnings momentum for three time periods based on the change in estimated earnings for the S&P 500 companies. A positive change in earnings expectations is bullish, but a flat or negative change in expectations is bearish. We rely on FactSet for these specific estimates. Note we score earnings momentum vs. the most recent month-end, again emphasizing the momentum.
We are scoring the second quarter 2017 earnings. Second quarter 2017 earnings are currently estimated at a growth rate of positive 10.3%, up 13.2% from the end of July 2017 (the most recent prior month-end), when the estimate was 9.1%. This higher expectation vs. the prior month's ending estimate is judged bullish in our scoring, since we require a positive percentage change to earn a bullish score.
Calendar year 2017E annual earnings are now projected by the street at a positive growth rate of 9.4% vs. a positive growth rate of 9.5% at the end of July. Since this is down vs. the prior month end, we score this as bearish.
Calendar year 2018E annual earnings are now projected by the street at a positive growth rate of 10.9% vs. 11.2% at the end of July. Since the change in this expectation vs. the prior month end is less than zero, this is scored bearish. These three indicators add up to two bearish and one bullish point.
We score the valuation of the S&P 500 on a PEG ratio (P/E to growth rate) basis. As stated above, a trailing P/E ratio (using earnings through 6/30/17) of 19.6x is compared to the trailing growth rate. As of 6/30/17 the trailing four quarters growth rate stood at 8.15%. The resultant PEG ratio is 2.40x, which is lower than our cutoff of 2.58 times. Anything above 2.58 is bearish, while values below 2.58 are bullish. We use 2.58x as the cutoff based on an historical P/E of 15.5 times, and historical earnings growth of 6%. Since the S&P looks cheap valued on a PEG basis, we score this indicator as bullish.
Thus, overall earnings momentum as we judge it now scores bullish since four out of our six indicator points scored bullish and two bearish.
Monetary Indicators: Neutral
Our excess liquidity indicator is bullish at 9.6 basis points. This means the Fed is providing 0.096% more liquidity than the current nominal GDP growth rate. This figure takes into account the decreased velocity of money in recent periods. We arrive at this figure by subtracting the annual percent change in velocity from the year over year percent change in M2 money supply. Then we subtract the most recent quarter's year-over-year percentage change in nominal GDP. We score this amount of excess liquidity as bullish. However, we should point out this is a very small amount of excess liquidity, and it may be indicative that the Federal Reserve really is starting to take away the proverbial punch bowl.
The second estimate of Q2:17 real GDP growth came in at +3.0%, better than Q1:17 which grew only 1.2%. Nominal GDP was reported at $19.247 trillion, up 3.8% year over year, and up 0.99% sequentially vs. Q1:17. We use this figure in the above calculation. Also, velocity of M2 money continues to decline. The most recent reading, 1.427, is down about 1.9% from a year ago.
As a reminder of the trend we are experiencing, we present below a graph of the velocity of M2 since its peak around Q3:1997 until the present.
We score the forward rate yield environment as bearish. Here, we are looking at just the short end of the curve, between three and twelve months. This is one point bearish.
Looking at a longer term comparison, the Treasury yield curve is accommodative to growth. We compare the ratio between the constant maturity one-year Treasury rates and ten-year rates, which is about 0.52:1.00 (1.23% vs. 2.13%), and this produces a positively sloped yield curve, and we score this bullish. This accounts for one bullish point.
The spread between Junk bonds yields and Treasury bonds has contracted. Using the HYG fund as a proxy, the yield-to-maturity of that fund stood at 5.18% this week and the spread vs. 10 year Treasuries stands at 3.05%, and this is bearish, since we judge anything over 4.00% as wide enough to rate bullish. We are applying a contrarian view point to score this. This is another one bearish point. The chart shown below shows the recent history of the breakeven inflation rate between 10-year Treasuries and 10-year TIPS.
Overall, with two out of four points scoring bullish, the monetary supply indicators are neutral.
In summary, our MMI score sits in bearish territory as of September 3, 2017. Technical, Valuation and Earnings Momentum indicators scored bullish, Monetary indicators scored neutral and Market Sentiment and Liquidity indicators scored bearish. We divide the number of bullish indicators points in each category by the total number of potential points in that category, and multiply the result times the weight each category carries out of 100% (each of the six categories being between 10% and 20%). The result this week is 49.67 points. This week's bearish score is the fifth out of the past six weeks the MMI have scored bearish. The NASDAQ and Russell 2000 hit their last peak in late July, and the S&P 500 and Dow Jones 30 Industrials did likewise in early August. Since then these major indexes have lost a small amount of ground, and remain within striking distance of those peaks.
Singular's Major Market Indicators (MMI) analysis weighs a large number of factors impacting the domestic equities market, gauging the temperature of the market. The MMI is a yardstick which measures whether we should be more bullish, or neutral, or bearish.
Rather than rely on anecdotes, or just one or two rules of thumb, we scour the investment landscape, scoring the indicators we believe are most representative of influencing the near to mid-term outcome of the market. We judge each indicator independently, based on its historical behavior, to determine whether it implies a bullish scenario for equities. We weigh and total our scores, producing a composite total to guide our investment posture.
Is the data telling us of impending bearishness? Or should we expect a breakout of bullishness? Or are we somewhere in-between? We produce an MMI score weekly answering these questions. The indicators are meant to serve as a guide to what to expect over a three to six month forward horizon. They are not intended to predict any particular day, or next week's, price action.
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Buy, 30% or greater increase in the next 12 months.
Buy - Long-Term, near term EPS horizon is challenging, attractive long-term appreciation potential.
Hold, perform in line with the market.
Sell, 30% or more declines in the next 12 months.
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