Dec. 31, 2017: Major Market Indicators Strategy Report
The MMI Are Neutral as the Equity Market Concludes a Fabulous Year
The MMI (Major Market Indicators) Index flashed a neutral score as of the end of 2017, while equity indexes in the U.S. ended the year not far from their record high levels reached earlier in the month. The MMI looks at what the markets are saying, scoring a large number of indicators which individually could support prices in the future, and right now the outlook is neutral. The MMI is in the middle of the neutral range, implying the indicators are not necessarily forecasting further gains or forecasting market losses either.
Our weekly calculation of the Major Market Indicators scores neutral this week, as the MMI ended at 54.17 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.
We've just completed an impressive year and an impressive run for stocks. 2017 did not experience a down month, which is incredible. Since the market bottomed from its most recent significant correction in February 2016 (has it been that long?), the major indexes have delivered simply remarkable results. The chart below shows returns since mid-February 2016 and for calendar 2017.
The S&P 500 has experienced a series of peaks and valleys over the past three-plus years. 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 gone up, with no worse than one 5% pullback (we won't even call that a correction). The major indexes (S&P 500, Dow Jones Industrial Average, Nasdaq Composite, Russell 2000) all hit new all-time highs this past month and sat not far from those heights as the year closed.
Below is a graph of the S&P 500 from Oct. 15, 2015, until last Friday, Dec. 29, 2017. Note the inflection point right after the election - the "Trump Bump." The unimpeded run-up of the equity markets since the election is impressive, but how long can it last?
Below, the weekly graph of our Major Market Indicators shows the trend since December 2016 through the end of last week.
The extended period the market has run without a meaningful correction is truly remarkable. Every investor has heard the statistics. The MMI is not warning us of an imminent downturn, although one can occur due to unforeseen shocks. The recently signed tax cut legislation is no doubt a positive contributor to earnings in 2018 as well as corporate balance sheets (via reduction of deferred tax liabilities). However, there is always the risk the Federal Reserve makes a mistake in tightening too fast (or tightening at all?), or measured inflation rearing its ugly head, international shocks emanating from North Korea or the Middle East or who knows where else, or high leverage globally in "real" debt with default potential and even more so in the gross notional value of derivatives outstanding - the list of pitfalls is a long one. And then there is Bitcoin!
For now, the MMI indicate a sanguine environment, and we accept that. The MMI index is an approach designed to take some of the emotion out of the process and measure what the markets are telling us. Right now, the markets are telling us the backdrop to investing is neutral. 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 indicative of a relatively supportive environment.
Why should you care what the MMI says? Well, it gave a valid warning signal the last time the market experienced a correction. The chart below displays the MMI weekly scores before/during/after the correction in early 2016. Note how it turned bearish starting on Sunday, Dec. 6, 2015, and stayed that way until Sunday, Feb. 7, 2016.
Now compare this with the performance of the S&P 500 over the same period. The MMI gave a few weeks' warning before the worst of the damage occurred in early January. This gave investors an opportunity to set up protection in one manner or another. Furthermore, it turned neutral just before the correction ended, giving a second useful signal. That's why you should care what the MMI says!
The MMI Index 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 2014.
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 eight indicator points out of twelve bearish and four 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 11.04 and 15.68. We require both of these indicators to register above 20.00. Implied volatility, when it has gone up, has come back down rather quickly over the past few years as evidenced by the graph below. Implied volatility continues to remain very low. This indicator scores one point bearish. The Put-Call ratio on the S&P 100 ended the week at 76/100, 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, 1.30 was bearish, since it was below our benchmark of 1.50 for bullishness. That's one point bearish.
The confidence index, the ratio of the index of high-grade bonds yield versus intermediate grade bonds yield (3.29%/4.16%), produces a ratio of 79.1%; we score any spread over 75.0% as bearish. That's one point bearish. The AAII (American Association of Individual Investors) survey of investors registered a ratio of bullish to bearish attitudes of 2.56, and since a ratio above 1.00 shows a tendency for individual investors to lean slightly to the bullish, we score this as a bearish reading (the contrarian viewpoint again). That's another one point bearish. Finally, the Consensus Index (78%) and the Market Vane Index (70%) were both above a 50.00% reading, and thus we score these as two points bearish. So that's eight indicator points scoring to the bearish.
On the bullish side of the ledger, the TIM Group Market Sentiment Indicator (43.00%) ended the week with a reading below 50.00%, and thus we score it one point bullish. The ARMS index on the Nasdaq, 1.62 was bullish, since it was above our benchmark of 1.50 for bullishness. That's one point bullish. Finally, the short ratio on both the NYSE and the Nasdaq (as of the last reading on Dec. 15) were bullish, at 4.50 days and 4.14 days to cover for both these markets, respectively, which is two points bullish. This adds up to four bullish indicator points.
The volatility chart below, though Dec. 31st, demonstrates what all investors are acutely aware of: low implied volatility persists, and has accompanied a remarkable year for stock market performance, with not a single month of negative returns for the S&P 500.
We like to refer to the chart below, since it's an alternative take on sentiment. This chart seems to confirm the score of our indicators that sentiment has raised close to the euphoric level.
To summarize, eight points scored bearish and four bullish - thus the market sentiment category scores bearish for the week.
Technical Indicators: Bullish
The major indexes continue their climb with seemingly little resistance. Our technical indicators scored bullish, with 10 of 15 indicator points bullish this week.
On the bullish side of the technical indicators, we scored eight bullish points from the indexes we track. We score specific indexes versus their 200-day moving average at the week's end. Since these indexes are above their respective 200-day moving averages, they all score bullish. The indexes we score were above their 200-day moving averages at the end of this past week by the following percentages: the S&P 500 by +7.71%, the Dow Jones Industrial Average by +11.80%, the Nasdaq Composite by +8.38%, the NYSE Composite by +7.03%, the Guggenheim S&P 500 Equal Weight ETF (NYSEARCA:RSP) by +7.19%, and the Guggenheim S&P SmallCap 600 Equal Weight ETF (NYSE:EWSC) by +7.76%. 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. Thus, the indexes generated eight points to the bullish. Additionally, the ratio of new highs to new lows at the end of this past week was 3.97x, and since this is above our benchmark of a 2:1 ratio, this is one point bullish. Finally, the advance/decline weekly volume ratio on the NYSE was 1.13. Since we require a score for this ratio of over 1.12 to rate as bullish, this volume ratio scores one bullish point. Thus, the total number of bullish indicator points adds up to ten.
Five of a possible 15 points in our technical score were bearish. The advance/decline weekly volume ratio on the Nasdaq was 0.79. Since we require a score for this ratio of over 1.12 to rate as bullish, this volume ratio scores one bearish point. We score the advance/decline ratio of the number of stock issues rising versus falling. The NYSE achieved a ratio of 1.26, and the Nasdaq registered a ratio of 1.32. We require these ratios to be greater than 2.00 to score bullish, so these metrics together generate two bearish points. Also, we score the 10-day moving average of up versus down volume on the NYSE and Nasdaq. The 10-day moving average of the NYSE and Nasdaq was 1.26 and 1.32, respectively. The required ratio for a bullish score is 1.50, so this metric produced another two bullish points. In summary, that's a total of five bearish indicator points.
Thus, we have a total of ten indicator points bullish and five indicator points bearish. Therefore, we rate the technical indicators as bullish overall.
Liquidity Indicators: Neutral
Our liquidity indicators are neutral this week. Money market funds balances are 9.56% 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 26.4% 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 two bearish readings.
Offsetting this was a bullish reading for 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 bullish 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 ($11.3) billion withdrawn by investors from funds for the four weeks. Net flows to ETFs over the four weeks continued positive, while outflows from traditional mutual funds continue negative, although the most recent week demonstrated strong inflows to traditional funds. This trend has persisted for some time now - 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 $61.4 billion. Far and away the largest contributor to this figure was the acquisition of Aetna (NYSE:AET) by CVS Health (NYSE:CVS) with a $47.3 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 $64.5 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. Buybacks continue to support the market as a continuously reliable source of demand for shares, though at a slower pace than in prior quarters. The largest announcements these past four weeks was by Boeing (NYSE:BA) for $18 billion and Oracle Corp. (NYSE:ORCL) for $12 billion.
IPO activity in 2017 increased versus a depressed 2016. We capture the total value of new market capitalization added to the market. The past four weeks saw only $7.1 billion of new market capitalization added via the IPO market. There were no really large IPOs in the past four weeks. We treat IPO activity as a reduction of liquidity. The chart below shows the annual proceeds from IPO issuance since 2007.
Source: Renaissance Capital and Singular Research
Secondary stocks offerings are also treated as a reduction of liquidity, and constituted $7.5 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.
We make a separate calculation of the value of shares sold by CEOs and other corporate insiders. Insider selling pulled $4.9 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 $3.39) billion in November (December 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 $98.5 billion for the past four weeks, which is more 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 bullish. We double weight this calculation in our MMI scoring, so this calculation above produces two points bullish. Combined with the other factors above, we score liquidity as neutral, as two out of a potential four points scored bullish.
Valuation Indicators: Bearish
Our valuation indicators score at a bearish level this week. Our fair value target for the S&P 500 is 3167, representing an 18.5% upside from the close on December 29th. 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 24.0x multiple applied to 2017's estimated operating earnings of 131.76. 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 20.8 times the trailing four quarters operating earnings (through the third quarter of 2017), compared to an historical norm of 15.5 times operating earnings. It is now trading at 20.3x 2017E and 18.2x 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 versus the week's close of 6.62%. Since this is less than a 10% potential gain, it scores bearish. 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 one point bullish and one point bearish 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 No Load (MUTF:PRNHX) to the P/E of the S&P 500. This ratio, at 1.58 times, is greater than our benchmark of 1.50x necessary to justify scoring it bullish, so therefore it is one point bearish. We note this is implicitly saying that small-cap stocks are expensive relative to large-caps.
Compared to GDP, the market (using Wilshire's total market value-Full Cap) is at a 52.4% 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 100.65% of replacement cost of the asset base of non-farm, non-financial corporate businesses. This metric is our version of Tobin's q. Since this is just barely more than 100% of replacement cost, we score this indicator as one point bearish. Finally, we divide the earnings yield of the S&P 500 by the Merrill Lynch Corporate BBB effective bond yield. The resultant ratio, 1.08x, is greater than one, and thus it is bullish. By our records, this ratio stood at 1.17x in February 2007 (and a ridiculously overvalued 0.44x in March 2000). Note, we are giving this indicator a lot of latitude - it has to fall below 1.0x to score bearish.
Overall, with valuation indicators scoring two bullish and four bearish indicator points (out of a possible six points), we rate the overall category as bearish.
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 third quarter 2017 is complete. In Q3, the S&P companies reported a positive to negative ratio of earnings surprises at 3.80x, 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 versus the most recent month end, again emphasizing the momentum.
We are scoring the third quarter 2017 earnings. Third quarter 2017 earnings are, at the end of December, currently estimated at a growth rate of positive 6.4%, unchanged from the end of November 2017 (the most recent prior month end), when the estimate was 6.4%. This unchanged expectation versus the prior month's ending estimate is judged bearish 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 9.6% versus a positive growth rate of 9.5% at the end of November. Since this is an increase versus the prior month end, we score this as bullish.
Calendar year 2018E annual earnings are now projected by the Street at a positive growth rate of 11.8% versus 11.1% at the end of November. Since the change in this expectation versus the prior month end is positive, this is scored bullish. These three indicators add up to two bullish and one bearish points.
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 9/30/17) of 20.8x is compared to the trailing growth rate. As of 9/30/17, the trailing four quarters growth rate stood at 8.69%. The resultant PEG ratio is 2.39x, 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 five out of our six indicator points scored bullish and one bearish.
Monetary Indicators: Neutral
Our excess liquidity indicator is bullish at 2.7 basis points. This means the Fed is providing 0.027% 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 that this is a very small amount of excess liquidity, and it is indicative of reduced Federal Reserve support. That is consistent with Fed statements asserting it is starting to "not refill the proverbial punch bowl."
The third estimate of Q3 2017 real GDP growth came in at +3.2%, which marks the second quarter in a row of 3% or better GDP growth. Nominal GDP was reported at $19.501 trillion, up 4.1% year over year, and up 1.30% sequentially versus Q2 2017. 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 1.2% 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 3 and 12 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 0.72/1.00 (1.75% vs. 2.47%). This produces a positively sloped yield curve, and we score this bullish. It 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 5.57% this week and the spread versus 10-year Treasuries stands at 3.10%, and this is bearish, since we judge anything over 4.00% as wide enough to rate bullish. We are applying a contrarian viewpoint to score this. This is one more 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 neutral territory as of Dec. 31, 2017. Technical and Earnings Momentum indicators scored bullish, Liquidity and Monetary indicators scored neutral, and Liquidity and Market Sentiment 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 contributes out of 100% (each of the six categories being between 10% and 20%). The result this week is 54.17 points. This week's neutral score is the ninth out of the past ten weeks the MMI posted a neutral score. The S&P 500, Dow Jones 30 Industrials, and Nasdaq all hit their peak price levels this past month, but the Major Market Indicators are only sending a neutral signal at week's (and year's) end.
Singular's Major Market Indicators - Methodology
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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