The "State of the Markets"...
Another week, another all-time high. Ho-hum.
Despite the relentless rise in stock prices, the current market environment seems to offer an awful lot for analysts to complain about. There is the lack of volatility, something that hasn't been seen for decades. There are the valuation levels, which, at the very least, have become extreme (and are worsening). There is the rate of the recent rise, which is starting to look a bit "parabolic" and purportedly tied to the passing of the Trump tax plan. There are concerns about inflation. There are worries about the ability of corporate earnings to continue to deliver. There is the Bitcoin mania. And finally, there are my seemingly constant whining that the indicators aren't as strong as they "should be."
However, if there is anything that I've learned about the markets over the last 30 years, it is that Ms. Market doesn't give a hoot about what we "think" should be happening in her game. In addition, it is important to note that moves such as we are seeing now can drive a bear to drink as they tend to last longer than almost anyone can imagine.
Thus, I believe the key to this environment isn't to try and figure out what is "wrong" with the market (remember, markets are never wrong, but traders often are), but rather to recognize that we have to play the cards we are dealt. In other words, it is what it is and we need to deal with it. So, from my seat, we must keep in mind that the bulls remain in charge of the game but, as I've been saying for some time now, this is not a low-risk environment.
The State of the Big-Picture Market Models
Let's start with my "executive summary" of the state of the market - I.E. a review my favorite big-picture market models, which are designed to tell us which team is in control of the prevailing major trend.
- The Leading Indicators model, which was our best performing timing model during the last cycle, is in pretty good shape.
- We have recently upgraded our "State of the tape" model to include an additional 5 indicator readings. The current reading of the new model has pulled back a bit recently but remains positive.
- The Risk/Reward model continues to fret about sentiment and monetary conditions.
- If I had to manage money from a desert island and could only use one model, it would be this one - a combination of internal and external factors. Currently, the model remains on a long-term buy signal, however, the model reading is only modestly positive.
- The newly expanded External Factors model includes a total of 10 indicators ranging from earnings, yields, sentiment, monetary, economic, and volatility. The current model reading is modestly positive. But, green is green, right!
- As I wrote last week, the models suggest stock market returns in excess of the historical average. So, the bottom line is the bulls remain in charge.
The State of the Trend
Digging into the details, I like to start my weekly review with a look at 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.
- Feel free to file this under the "duh" category, but the short-term Trend Model remains positive this week. Ditto for the Intermediate-Term Trend Model
- With the S&P breaking to new all-time highs, both the short- and intermediate-term Channel Breakout Systems are positive and on buy signals.
- The long-term Trend Model also remains positive this week.
- The Cycle Composite suggests that the trend tends to be sloppy at this time of year.
- The Trading Mode models all agree that this remains a trending environment. Which again can be filed under "duh."
- It is said that the most bullish thing a market can do is make new highs. And while the bears argue the action appears to be driven by the expectations for tax reform, I'm going to summarize with, "It is what it is."
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.
- Both the short- and intermediate-term Trend and Breadth Confirm Models are positive this week.
- The Industry Health Model managed to nudge its way up into the outright positive zone this week - albeit by the skinniest of margins. But since I have been complaining for some time about this model inability to turn outright positive, I will have to again recognize that "it is what it is."
- The short-term Volume Relationship continues to improve and while not as robust as I'd like to see (the demand volume line was higher in June), it IS positive.
- The intermediate-term Volume Relationship is positive and heading in the right direction. And while the overall reading is not as high as it was early in the year, a positive reading is positive.
- The Price Thrust Indicator remains in good shape and solidly green.
- The Volume Thrust Indicator requires a lot of internal "oomph" - which the market doesn't possess at this time.
- Ditto for the Breadth Thrust Indicator - the model remains neutral.
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.
- From a near-term perspective, stocks are once again overbought.
- From an intermediate-term view, stocks are also overbought, but not in an extreme fashion.
- The Mean Reversion Model remains neutral. With volatility so low, the model has been unable to move to levels required to trigger signals.
- The short-term VIX indicator remains on a sell signal. However, let's keep in mind that shorter-term, mean-reversion type of indicators have not been productive this year.
- Our longer-term VIX Indicator remains on a buy signal. However, this signal is quite "stale" by now.
- From a short-term perspective, the market sentiment model has slipped back into the neutral zone - but only by a slim margin.
- The intermediate-term Sentiment Model continues to flash a warning sign.
- Longer-term Sentiment readings remain at extremely negative levels.
The State of the Macro Picture
Now let's move on to the market's "external factors" - the indicators designed to tell us the state of the big-picture market drivers including monetary conditions, the economy, inflation, and valuations.
- Absolute Monetary conditions haven't budged - still in neutral zone.
- The Relative Monetary Model continues to be in the green zone. This could be considered a bit odd given the Fed's stance. However, the theme of this week is "it is what it is" so this remains something to pay attention to going forward.
- Our Economic Model continues to suggest a strong economic growth environment.
- The Inflation Model remains green to start the week. However, it is worth noting that the model reading has finally reversed and starting to go the other way. This would support the argument that "some" inflationary pressures may be starting to build.
- The Absolute Valuation Model is red and heading in the wrong direction. As such, any disappointment - especially on the earnings front - could be problematic.
- Our Relative Valuation Model remains neutral - but not by much. Thus, the takeaway is that valuations are worsening here.
Sample Risk Exposure System
Below is an EXAMPLE of how some of above indicators might be used in order to determine exposure to market risk. The approach used here is a "Model of Models" comprised of 10 independent Models. Each model included gives separate buy and sell signals, which affects a percentage of the model's overall exposure to the market.
Trend models control a total 40% of our exposure. The 3 Momentum Models and 3 Environment Models each control 10% of the portfolio's exposure to market risk. The model's "Exposure to Market Risk" reading (at the bottom of the Model) acts as an EXAMPLE of a longer-term guide to exposure to market risk.
In looking at the "bottom line" of this model, my take is that readings over 75% are "positive," readings between 50% and 75% are "moderately positive," and readings below 50% should be viewed as a warning that all is not right with the indicator world.
The model above is for illustrative and informational purposes only and does not in any way represent any investment recommendation. The model is merely a sample of how indicators can be grouped to create a guide to market exposure based on the inputs from multiple indicators/models.
Thought For The Day:
To be able to ask a question clearly is two-thirds of the way to getting it answered. -John Ruskin
Current Market Drivers
We strive to identify the driving forces behind the market action on a daily basis. The thinking is that if we can both identify and understand why stocks are doing what they are doing on a short-term basis; we are not likely to be surprised/blind-sided by a big move. Listed below are what we believe to be the driving forces of the current market (Listed in order of importance).
1. The State of Tax Reform
2. The State of the Economy
3. The State of Fed Policy
4. The State of Earnings Growth
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.
Industry Health Model Explained: Designed to provide a reading on the technical health of the overall market, Big Mo Tape takes the technical temperature of more than 100 industry sectors each week. Looking back to early 1980, when the model is rated as "positive," the S&P has averaged returns in excess of 23% per year. When the model carries a "neutral" reading, the S&P has returned over 11% per year. But when the model is rated "negative," stocks fall by more than -13% a year on average.
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 -8.5% 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 wnen 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 indicators 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 a intrmediate-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 cliche, "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 actually 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.