IJH: Hold Current Position

Summary

• The macroeconomic backdrop is positive.
• There are, however, modest signs of weakness in the wage data.
• IJH continues to consolidate its rally from the Spring 2020 lockdowns.

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My basic methodology when looking at an ETF that tracks a broad index is to first look at the macroeconomic backdrop. I then look at the charts to determine if this is an appropriate time to go long (if the economy is expanding) or short (if the economy is contracting).

Investment thesis: maintain your current position in the (NYSEARCA:IJH) but don't add to it.

Introduction: ETFs now form the backbone of most portfolios. For example, a standard portfolio is composed some ratio of SPY (for the S&P 500) and TLT (for the long-end of the treasury market). In addition, due to low cost and high liquidity, an increasing number of investors and managers are now favoring ETFs that track broad averages over large mutual funds. Hence, an analysis of a large index-tracking ETF such as the IJH is warranted on Seeking Alpha as this is now a standard investment tool used my many investors.

General investment theory is that smaller-cap indexes are riskier. A corollary to that rule is that investment risk diminishes as the market cap of the underlying security or components of the underlying index increase.

The general investment methodology recommended by investment managers is that younger investors -- due to long length of time during which they have time to accumulate assets (usually in a tax-deferred investment vehicle such as a 401(k) or IRA) -- should invest in riskier investments. In the ETF world, a good choice would be the IWC (a broad micro-cap index) or the IWM (which tracks the Russell 2000 small-cap index).

The IJH should be used by somewhat older investors (between say, 35-50). These investors can still benefit from the risk of somewhat smaller index components, but will also want to start lowering their investment risk by increasing the underlying market cap of their core investments.

The performance of broad macro indexes such as the IJH are inextricably tied to the economic cycle. A growing economy feed corporate profits, which in turn increase PE rations, which, in turn, increases the broad index's market valuation and, hence, share prices. The reverse is also true: decreasing economic activity decreases sales, which decreases PE ratios, which lowers index valuation. This relationship explains this columns inclusion of a broad macro-economic analysis.

I have chosen to use the IJH as a proxy for mid-caps because this ETF is extremely liquid and is the largest mid-cap ETF based on the number of assets under management.

Today, I'll use the long-leading, leading, and coincidental indicator methodology developed by Arthur Burns and Geoffrey Moore of the Federal Reserve. This is also used by the Conference Board in its LEI and CEI indicators.

Long-leading indicators

The long-leading indicators are primarily composed of credit market and money supply indicators. These are more likely to show signs of strain somewhere between 12-18 months before a recession.

From the FRED system

Money supply (left) is still expanding at a brisk pace. The effective BBB yield (right) is still very low relative to its historical levels.

While corporate revenue and earnings growth are still positive, each is taking a hit from higher input costs:

The market has been focused on the rising cost of inputs and labor and other supply chain issue for the last few months. There was tangible nervousness on Wall Street ahead of the start of the Q3 earnings season that these headwinds would start weighing on corporate profits through compressed margins.

.....

While these unfavorable cost trends may not have had as much negative impact on earnings as many had feared ahead of the start of the Q3 reporting cycle, they still remain a risk to long-term earnings trends. In fact, a number of sectors where the margin cushion is already fairly thin, struggled with these trends.

Still, revenue and earnings projections are positive:

Leading indicators

These are still mostly positive:

From the FRED system

New orders for consumer durable goods (left) quickly rebounded after the sharp contraction during the recession. Nondefense capital goods orders (think manufacturing machinery) are at incredibly high levels.

From the FRED system

1-unit housing permits (left) peaked in January of 2021. They trended lower for most of 2021 as building supply costs rose. During the last two months, they have rebounded a bit. The average weekly hours of production workers (right) also rebounded quickly after the recession. They have trended modestly lower since the beginning of 2021 but aren't showing any signs of a major drop.

From the FRED system

There's been a slight uptick in the rate on 3-month commercial paper (left). But this is likely due to the Fed taking a more hawkish posture than market stress. The 4-week moving average of initial unemployment claims (right) continues to trend lower.

From the FRED system

The yield curve is positively sloped (left) while the stock market recently hit a new high.

Coincidental indicators

From the FRED system

The total number of establishment jobs (left) continues to rise. The jobs market has replaced about 80% of losses. The pace of establishment job creation (left) is still positive, although it has decreased in the last four months.

From the FRED system

Real income less transfer payments is higher than pre-pandemic levels. But the pace of increase has stalled in the last few reports, largely due to higher inflation.

From the FRED system

Industrial production (left) has recouped all its losses while retail sales (right) are at very high levels.

Economic conclusion: overall the underlying economic backdrop is positive. There is little sign of financial market stress, indicating there is little reason to be concerned about a recession. While there are signs of modest weakness (primarily in earnings data) the overall picture is still positive.

Now, let's turn to the charts:

2-year weekly chart (left) and 1-year daily chart (right) from Stockcharts.com

The weekly chart (left) shows that the IJH cratered with the rest of the indexes in the Spring of 2020. It rallied strongly from the end 03/20 to the Spring of 2021. Since then, the index has been trading sideways, mostly between the 260 and 280 level (right).

3-Month chart (left), 1-month chart (upper right) and 2-week chart (lower right).

The 3-month chart (left) shows the ETF has mostly trended between 265 and 290. It trended lower in the first half of December, but rallied in the second half.

With a positive economic backdrop and no sign of a recession on the horizon, we'd need a good reason to go short. None exists. But the index spent the better part of 2021 consolidating gains from its mammoth post-pandemic rally. Until the index breaks through to new highs, don't add to your position.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.