BULL-IEVE It or Not?

Our last monthly email was published on Monday, June 27, which in hindsight, turned out to be the conclusion of the two-day selloff in global stock markets associated with the United Kingdom Brexit vote.

In those two days, the S&P 500 fell nearly 6%, but has since rebounded nearly 9%, to a new all-time high.  The rally has been broad-based, with small, midcap and international indexes also gaining between 9 and 11% from the low.  A number of momentum indicators have generated strong thrust signals, a couple of which we’ll outline below.  Historically, though the number of occurrences are limited, past results have tended to be bullish for stocks.

Think of a rocket ship with boosters.  The boosters generate a tremendous amount of thrust to lift the rocket off the launching pad, and even after the boosters have flamed out, the rocket keeps on going, not just from its own engines, but from the momentum.  When upside momentum such as this takes place in the stock market, it has typically lasted several months.

The 10-day Average of the Advance/Decline Ratio

Many technical analysts track this indicator, which is a 10-day simple average of advancing stocks versus declining stocks.  One will get different results when using different thresholds, but most analysts focus on when the ratio rises to 1.9 to 1 or higher.  The table below is taken from Dan Sullivan’s Mutual Fund / ETF Letter. Sullivan restricts his signals to when the ratio rises to a 2 to 1 margin or more.

Using Sullivan’s criteria, there have only been 13 prior signals since 1949, and only one of those resulted in lower prices one year later, that being a near -6% loss following the 1987 occurrence.  The data above is based on using the Dow Jones Industrial Average.

In a similar study, Ned Davis Research (NDR) uses a criteria of 1.9 to 1.  A similar signal was generated on July 11, using this ratio.  They have data going back to 1947, and with a little less stringent criteria, there have been 47 prior cases.  Interestingly, 25 of these took place from 1947 to 2002, while 22 have occurred since 2003, perhaps due to the increased use of ETFs and high frequency trading.  But, the message is similar, in that the vast majority of outcomes have tended to be positive.

According to NDR’s study, looking out 252 days later, 43 of the 44 prior cases that have been completed have resulted in gains, with the only loss the same one as in Sullivan’s study above.  The median gain was just over 17%.  When looking out 126 days later, 39 of 45 completed signals have shown positive results, with a median gain of 10.5% and the largest loss being -13.3% in 2011.

Market Implications

There are never guarantees with markets, only probabilities.  Minimal declines are hallmarks of momentum thrusts.  Applying this to the S&P 500, the old high of 2130 now becomes support.  The index currently sits at 2170.  There should not be a decline of more than 3% to 5% in the next three months if there is to be another bullish outcome.

On the positive side, the advance/decline line has confirmed the recent high, and major tops usually have a divergence similar to the one in May 2015.  We are watching crude oil and high yield bonds.  Crude oil has quietly declined over 20% since early June, now sitting at $40.  Corporate high yield bonds also rallied sharply off the stock market Brexit lows, but have rolled over a bit in the past week while stocks have gone sideways.  This bears observation, as divergences between high yield and the stock market have typically been good warnings of future trouble for stocks.

The Fed and the Election

Despite the chatter last week from Fed Chairwoman Janet Yellen that an interest rate hike could be on the table for their September meeting, that is very unlikely to happen. Though the stock market is at or near its high, the Fed is quite data dependent, and the economic reports continue to show very slow growth.  Since the Fed is terrified of spooking financial markets, even with a minuscule 25 basis point increase, the likelihood is the Fed will not do anything until after the election.  I suspect they don’t want to be accused of interfering with the outcome, and the odds are stocks will decline after the next increase in rates, whenever that may happen.

If an increase is to come in the Fed Funds rate, my guess is that it will take place after the election, in December.  I’m certainly hoping for an increase, for the sake of bond and money market yields, but we’ll have to see.

Speaking of the election, investors may get a clue as to whether Hillary or Donald will win, by observing the performance of the stock market from August to October.  Though limited in scope from a statistical standpoint, in 19 of 22 prior cases, when stocks gained in this three month period prior to the election, the incumbent party won.  In English, if stocks are up, the odds are with Hillary, and if they’re down, the odds are with Donald.

Investment Allocations

Our stance with portfolios should be considered moderately positive.  Tactical equity exposure is at 65%, with another 3-5% in real estate, and our corporate high yield bond model remains on its February 29 buy signal.  So, we are participating in the advance, but are not fully invested.  Holding us back from increased exposure are seasonal considerations and an interest rate model.  The TABR Dividend Stock account is 80% invested.

What’s Not to Like?

Though the short term technical condition of the market is mostly bullish, not everything is hunky dory.  The New York Composite Index, made up of nearly 3200 companies (in comparison to the S&P 500) is below where it was in July 2014, along with the Dow Transports and international stocks as represented by the Vanguard Total International Index Fund.  In addition, the Russell 2000, a representative small company index, is barely above its July 2014 levels.

The fundamental valuations of stocks, using various methods, suggest a very expensive market relative to history.  Below is a chart courtesy of Ned Davis Research, showing the S&P 500 and its Median Price Earnings Ratio.

Using this study, stocks would need to decline almost 8% just to get to overvalued territory, which is defined as 1 standard deviation above the 52-year median.  To get to the median would require a decline of nearly 30%.  As I have noted many times before, fundamental valuation indicators are almost useless for timing, but they are helpful for risk and historical context.  From a historical perspective, stocks have only been this expensive three prior times—1929, 2000 and 2007.

At some point, what investors pay for stocks will matter, but as we’ve noted above, the technicals are presently mostly positive.  When that evidence changes, risk will be on a different level.

Material of a Less Serious Nature

Conjoined twins walk into a bar in Toronto and park themselves on two bar stools. One of them says to the bartender, “Don’t mind us; we’re joined at the hip.  I’m John and he’s Jim.  Two Molson Canadian beers, draft please.”

The bartender, feeling slightly awkward, tries to make polite conversation while pouring the beers.  “You fellas been on vacation lately?”

“Off to England next month,” says John.  “We go to England every year, rent a car and drive all over the place, don’t we, Jim?”

“Ah, England!” says the bartender.  “Wonderful country, the history, culture and especially the beer.”

“Nah, we don’t like that British crap,” says John.  “Hamburgers and Molson’s, that’s for us, eh Jim?  We can’t stand the English people either, they’re so arrogant and rude.”

“So why keep going to England?” asks the bartender.

John replies:  “Gives Jim a chance to drive. . . ”

Thanks, as always, for reading this far.  I know—some of you just skip right to the joke and move on!  We’re grateful for the trust and confidence you express in us daily.

Sincerely,

Bob Kargenian, CMT
President

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