Recently, the Wall Street Journal published an article, “The Biggest Money Mistakes We Make – Decade by Decade“, on the money mistakes that people make during their life at various age-levels. Their relationship with money and understanding of it evolves during their lifetime and they make different types of mistakes.
Young people in their 20s, either because of lack of knowledge or complacency, play it too safe and don’t invest aggressively. In 30s, people are overwhelmed by the complexity of life and in 40s they misjudge the big expenses. In 50s they struggle to catch up and in 60s they do not delegate to younger relatives their financial affairs.
Investing is Much Maligned
Despite demonstrable data that prudent investing leads to riches many people do not believe it. Investing confounds so many that they compare it to gambling.
Oxford Dictionary defines gambling as playing games of chance for money or taking risky action in the hope of a desired result. The dictionary defines investment as an action or process of investing money for profit or a thing that is worth buying because it may be profitable or useful in the future.
As we see, there is one similarity between them – both of them carry a level of risk. Like in gambling, people lose money in investing too but that does not make them as same. People lose money in other businesses too but nobody calls them gambling. And there is a reason for that.
All businesses, like gambling, are inherently risky. What separates them is the level of risk, probability of favorable outcome and how the risk is managed. In gambling the probability of winning is small, risk is large and there are very few methods of managing the risk. In business, normal opportunities have reasonable probability of success, associated risk is usually commensurate with the reward and there a many risk-management strategies that allow enough control over business activities. Investment is just another type of business and same rules apply.
Stocks Have A Built-In Up Bias
The human species is programmed for growth and change. It always strives for improvements and innovations, which humans usually manage and propagate through businesses. Stocks of the businesses just reflect their future potential, which by design has to rise in aggregate.
Since 1900, in nearly 117 years, the Dow Jones Industrial Average has returned +27137%, which results in +4.9% annualized. This does not include the dividend either reinvested or taken out. In other words this is just based upon the price and not the total return. The total return and annualized return since 1970 are +2142% and +6.9%.
The corresponding numbers for S&P 500 are +34755% and +5.1% from 1900 and +2401% and +7.1% from 1970.
When we drill it down more we find that on rolling basis the numbers look even better.
The Table 1 provides the total return, annualized return and draw down for 5-year, 10-year, 20-year, 30-year and 40-year rolling periods from January 1900 and from January 1970, a more recent time period, for Dow Jones Industrial Average. Table 2 provides the same date for S&P 500. Table 3 provides the data for S&P 500 Total Return Index, which is available from January 1988.
The average annualized return for a 10-year rolling period, since 1970, is +8.8% for DJIA and +8.7% for S&P 500. For S&P 500 Total Return index the 10-year average annualized return is 10.2%. During this time-frame, investing in DJIA over a 12 year period and investing in S&P 500 over a 13 year period have never been un-profitable.
Bottom line is it pays to be in the market.
In its last statement, released on November 2 at 2:00 PM, the FOMC did not raise the benchmark interest nor did the market expect it -three days before the release it had assigned a probability of 8.3% for a 25 basis point hike. Day after the meeting, the probability increased to 71.5% for a 25 basis points hike on December 14. from 68% on October 28. The latest FOMC statement is largely unchanged from last one. There were only two dissenter compared to three in last meeting.
In the past few weeks, so many FOMC members – both voting and non-voting – have made hawkish comments that in our opinion if the Fed does not hike Fed Funds rate by at least 25 basis points in December then it stands to lose a great deal of credibility. Off course, as Chair Yellen has said time-and-again that the Fed is data dependent, the rate hike may not happen if the data in November point to a weakening economy.
How The Data Is Shaping Up?
In our October newsletter, we mentioned some data points that needs to be maintained for Fed to be hawkish. These include 4-week average unemployment claims to be current level of 256K, the Non-Farm payroll should not disappoint, the 3-month average employment gain should be close to 200k, core CPI and core PCE should trend up and the inflation expectations should trend up.
The current 4-week average claims is 258K and the 3-month average employment gain is +199K. From August to September, the year-over-year Core PCE declined to 1.69% from 1.73%, the Core CPI declined to 2.2% from 2.3% and the University of Michigan Inflation Expectations declined to -14.28% from -10.71%. The CPI and PCE are generally rising since 2014 but have been stalling for the past few months. The rise in inflation expectation is less pronounced but the stall is.
Economic Data Is Improving
Still, there is no doubt that the U.S economy has been improving, albeit slowly, and so is the data, which has given rise to increased expectation of Fed Fund rate increase. A closer look at the numbers tell us that it is not a very straight forward assessment. The year-over-year changes have been slowing since late 2014 / early 2015.
Industrial production, Fig. 1, started to decline from year-over-year levels beginning January 2015. It has reversed trend by December 2015, although the change is still negative. Other data series in the Fig. 1 are still trending down. We think that a rate hike will prolong this down trend. Olivier Blanchard, former IMF chief economist, also thinks so too.
I am less optimistic. I still do think there is a chance that demand is strong and the labor market responds more than it has and we start seeing wage inflation and the Fed feels it really has to increase interest rates faster than it intended. My subjective probability that this happens is lower than it was six months ago, a year ago. But I think the markets should be aware of that possibility. I’m worried that some investors have not hedged against that.
Prof. Blanchard would like to see U.S. economy overheating more before Fed increases rates. So do we but Fed may not agree with us at the moment.
How Fed-Fund Rate Hike Impacts Market
Bottom line is that the Fed is turning hawkish and the data is improving but there is still a chance that it may falter. Nevertheless, the chance of a rate hike is very real. But, how bad is that is for the market? It is time to update our analysis done in 2015, when we wrote:
Since 1992, Fed has started the rates increase only four times. In February 1994, it started a rate-hike spree that took the rates from 3.00% to 6.00% by February 1995 in seven steps. In March 1997, it raised rates only once. Between June 1999 and May 2000, the Fed raised rates six times to 6.50% from 4.75%. Between June 2004 and June 2006, the Fed raised rates 17 times, taking the benchmark to 5.25% from 1.25%.
Since then Fed has increased rates in December 2015, only once, before stopping again. Table: 4 shows how the S&P 500, Dollar Index and 30-year U.S. Treasury bonds performed over a 4-week, 13-week and 26-week period after the first rate hike in the last 24 years.Over a 4-week period after the first rate hike, S&P 500 has always declined. U.S. dollar index has advanced 60% of times or three out five. The 30-year Treasury bonds advanced twice or 40% of times.Over a 13-week, or nearly 3-month, period, the equity index was up only once or 20% of times. The dollar index always declined and the bonds gained 60% of times.
Over 26-week period, stocks advance 80% of times. Dollar declines 80% of times and bonds decline only 40% of times.
The psychological indicators that we follow are not showing distress signs that indicate the market might decline sharply in the near future, however, some clouds are gathering for further weakening.
Bullish Vs. Bearish Advisors %
This is a contrarian sentiment indicator. The bullish sentiment with Investors Intelligence Bullish Advisors % has moved up to 47.10% from 45.20% since end of September. The Bear Advisors % has stayed the same at 23.10%. When the percentage of bears crosses over the bulls, the market bottom is likely. Last time bears were over bulls was in March 2016.
AAII Investor Sentiment Survey
As of October 27 2016, 24.8% of members of AAII are bullish regarding markets direction for the next six months. compared to 34.1% of members who are bearish and 41.2%, who are neutral. One month ago, these numbers were 24.0%, 37.1% and 38.9% respectively.
Bullish and bearish percentages are below the historical averages of 38.5% and 31.0% respectively. The neutral percentage is above the historical average of 30.5%. The bullish sentiment is at below its average for 51 consecutive weeks and 84 out for past 86 weeks.
At extreme readings, this gauge works as a contrarian indicator but at other times, it provides signs for future direction of the market. We have found that the current slope of the 4-week simple moving average of the bullish percentage gives a good sign for the slope of the S&P 500 4-weeks later (Fig. 2). Also, the spread between bullish and bearish percentages gives a hint for future direction of the S&P 500.
In the most recent reading on October 27, the 4-week bullish percentage average increased to 25.7% from 25.5% on October 20. After making 2016 high during the week of July 28, the 4-week average has mostly declined. This does not bode well for S&P 500. However, this just gives an indication regarding the direction and not the magnitude of the move. The 4-week average of bullish-bearish percentage spread is negative for seven week, i.e. there are more bears than bulls.
CBOE Market Volatility
October, like September, saw an increase in the market volatility. Before September 9, S&P 500 had not closed more than 1.0% – in either direction – from previous day’s close since July 8.
At the beginning of October, $VIX, the CBOE Market Volatility Index, was at 13.29 (Chart 1). After declining for few days, it rose to reach a high of 17.95 on October 13. Then the volatility declined to 12.73 by October 25 before closing the month at 17.06, which is above the 12-month (15.85), 24-month (16.62) and 60-month (16.43) averages. It is also above 20-day, 50-day and 200-day averages, though below September high of 20.51. On November 4, $VIX closed at 22.51.
In a nutshell, $VIX is indicating that the market anxiety is at an elevated state and could increase, which will translate in S&P 500 declining.
A contrarian sentiment indicator that helps determine major and short-term market tops and bottoms is the Put/Call Volume Ratio, which compares the total number of puts traded with total number of calls traded. The ratio was 0.970 by the end of October (Chart 2). A reading above 1.00 indicates that investors are turning bearish and a reading above 1.15 usually confirms a positive reversal.
The 10-day moving average gives a better indication of short-term bottom. The end of October value is 0.979. On November 4, this ratio was 1.110 and the 10-day moving average was 1.004. Following Brexit referendum, the ratio reached 1.170 and the index turned around. This is hinting that more weakness is expected in the near future.
This is a IBD proprietary indicator that helps in determining rebounds from immediate corrections during bull markets. It was at 1.083 by the end of October compared to 2.00 at the end of September. A short-term bottom usually occurs when it turns up for the first time after crossing below 0.5. During bear market this threshold level drops to 0.1.
The NYSE New High / New Low ratio has been trending down since July. October’s reading was 0.733 (Chart 3). It was 0.0021 in February before the index staged a turn around. On November 4, this ratio was at 0.5600 after falling to 0.15680.
Another contrarian indicator that denotes the year-over-year change in NYSE margin debt, which can help flag major tops in bull market. When optimism is high this will exceed 55%, which means that investors are borrowing heavily during the late stages of bull market.
At the end of September, it was +10.4%, which means that the investors have increased their margin debt from the year-ago level (Fig. 3).
The fundamental picture does not look too bad. The year-over-year earnings grew for the first time in seven quarters. The forward P/E is above 10-year average but not near bubble territory, though, it shows room for 10-5% decline unless companies announce earnings upside. Part of the reason may be the impact of strong dollar on depressing US companies’ earnings from foreign.
S&P 500 Companies Reporting Growth For Q3 2016
As of October 31, 60.6% of S&P 500 companies have reported Q3 2016 earnings. Out of these, 72.6% have beaten the forecast and 19.6% have missed. These figures are better than the average since Q2 2013 (67.7% beat and 22.6% miss).
The blended year-over-year earnings growth rate (actual reported earnings and estimated earnings combined) for Q3 2016 is 1.6% (Fig. 4), which is better than the estimated decline of -2.2% at the end of September (as reported by FactSet). If the trend holds then this will be first year-over-year growth of earnings since Q1 2015.
In aggregate, companies are reporting earnings that are +6.7% above the estimates, which is higher than the 5-year average of +4.4% and 1-year average of +4.8%.
The blended sales growth rate for Q3 2016 is 2.7%. If the trend holds than it will be the first year-over-year sales growth since Q4 2014. In aggregate, companies are reporting sales that is +0.8% above expectations, which is higher than 5-year average of +0.6% and 1-year average of +0.0%.
The upside earnings surprises reported by S&P companies to date have led to a $10.1 billion increase in earnings for the index since September 30. All eleven sectors have higher growth rates by the end of October compared to that on September 30.
More Companies Beating EPS and Sales Estimates To Date Than Average
By October 28, 58% of S&P 500 companies had reported Q3 2016 earnings. Out of theses 74% have reported earnings above the mean estimate, which is higher than 5-year average of 67% and 1-year average of +70%.
58% of S&P 500 companies have reported sales above the mean estimate, which is higher than 5-year average of 54% and 1-year average of 50%.
The 12-month trailing EPS has been declining since Q3 2014 but the S&P 500 is either staying flat or rising (Fig. 5). This usually does not happen. In 2011-2012, the EPS war rising but the index was falling. The 12-month Forward EPS gives a better relationship with the price (Fig. 6).
Forward Estimates and Valuation
According to FactSet Research Systems Inc., analysts expect earnings and revenue growth to continue in Q4 2016. For the quarter, analysts are estimating the earnings growth to be +4.6% and revenue growth of +5.2%. The corresponding numbers for the year 2016 are +0.2% and +2.2%. Analysts are estimating the earning growth of +12.0% and revenue growth of +5.8% for 2017.
For Q4 2016, 36 S&P 500 companies have issued negative EPS guidance and 21 companies have issued positive guidance. The percentage of companies issuing negative guidance, 63% or 36 out of 57, is lower than the 5-year average of 74%.
The forward 12-month P/E ratio for S&P 500 is 16.4, which means that the estimated earnings is 129.66. The current ratio is higher than the 5-year average of 14.9 and 10-year average of 14.3 but is slower than the ratio at the end of September 30, which was 16.8. In October, the price of S&P 500 decreased by -1.9% and the earnings estimates increased by +0.8%.
November is the third best month for S&P 500, Dow Jones Industrial Average, NASDAQ Composite and NYSE Composite since 1970. It is the sixth best for Russell 2000 and the best month for Dow Transportation Average. Since 2000, the ranking changes. after 2000, November is the fifth best month for S&P 500 and NYSE Composite. For all others it is fourth best month.
November also the begins the Best-Six Month Switching Strategy popularized by Stock Traders’ Almanac. All major U.S. indices have gained during November with Dow Transportation Average being the best performer. Since 1970, its average gain of the month is +2.3% (Fig 7). The average rises to +2.4% after 2000. It has also been up 81% of times since 1970 and 74% since 2000 (Fig. 8).
The behavior of the market is a bit different in the presidential election year. October is usually the worst month of the election year. This year S&P 500 declined by -1.9% in October, its second worst monthly decline of the year, extending the streak of down months to three.
Since September 2011, S&P 500 has not had four consecutive down months. That is good. The bad is that although November has 67% chance of being an up month (based upon data from 1970), that chances drops to 63% following a down October. The corresponding numbers for period after 2000 are 69% and 60%.
U.S. Presidential Election
As the probability of a Trump victory increase, S&P 500 (Fig. 9) declines but gold (Fig. 10) and U.S. treasury bonds (Fig. 12), which happens when the market uncertainty is elevated. Higher market uncertainty may decrease the chances of Fed Fund rate-hike in December following the election, which is reflected in the declining U.S. dollar (Fig. 11).
Commodities and U.S. dollar are inversely related. If one rises then other declines. Since October 24, both are declining, which coincides with rising poll numbers of Donald Trump. Market views this an uncertain future. In an uncertain world the economic activities slow down. This reduces the demand for commodities like crude oil and industrial metals. Fall in $CRB (Chart 4) is showing that. Slowing economy diminishes the chance for Fed Fund rate hike. Falling U.S. dollar is showing that.
Since early July, the 30-year US Treasury $USB, (top panel Chart 4 ), has been falling. It briefly rose in September before resuming the down trend. In last October, it has again started to rise. The decline in the bond is related to increasing expectation of Fed Funds rate hike. The recent uptick is related to the uncertainty of U.S. presidential election.
These two phenomena are impacting other three asset classes too. Equities, S&P 500 or $SPX, have been declining for some time (second panel Chart 4 ). For better part of September and October, the index was within a trading range. In the later half of October, as the election date come closer, it started to decline breaking many support levels.
The commodities as represented by Reuters/Jefferies CRB Index, $CRB, were rising for September and most of October (third panel Chart 4 ). This usually results in higher inflation expectations, which increases the probability of Fed Fund rate hike. However, commodities turned down along with equities in the second half of October.
The trajectory of U.S. dollar index, $USD, is similar to that of commodities (bottom panel Chart 4 ). But, it is reacting to the Fed Fund rates hike directly and indirectly to the election uncertainty. We are not going to analyze the U.S. president except for noting that there is some link between the decline in the market and increasing odds of Donald Trump presidency. This link has been more pronounced in the past few days. Also, other asset classes are showing a relationship too.
On weekly time frame these asset classes paint a different picture (Chart 5).
Even though the 30-year US Treasury Bonds have broken an uptrend line from the lows of 2014, the trajectory is still up (Chart 6).
The price has declined by -8.12% from a high of 176.06 to 161.75 on November 3 but it has not yet made a lower high and lower low. It is also at 89-week SMA. The 14-week RSI is at the level which resulted in bounces in 2015.
For an uptrend to turn into a down trend we consider three events – 1) a break of trend line, 2) a lower high and lower low, 3) a bounce and resistance at the broken trend line. By this criteria standard, bonds have not yet changed direction.
Reuters/Jefferies CRB Index made all time high of 473.97 in July 2008. It then declined to a low of 200.16 by February 2009. The bounce from that low faced a resistance at 61.8% Fibonacci level of 369.375. The high reached in April 2011 was 370.71. The index then traded in range of 100 points before breaking support in last 2014 and early 2015. The decline in early 2016 took the index to all time lows of 154.85 (Chart 7).
Since then, $CRB has been staging a turnaround but is facing a resistance near 200, which was the low of 2009 and is acting as a resistance. The price is at 89-week SMA. The 14-week RSI is near 50 level after crossing above. The chart pattern shows an up bias but for that to materialize the price has to break above 195.88.
For most of the period between 2009 and 2015, U.S. Dollar Index, $USD, traded within a range bounded by an upper limit of 89.11 and a lower limit of 72.70. After breaking above it in early 2015, it formed another trading range between 100.71 and 91.88 (Chart 8).
The first trading range lasted for nearly six years. The current trading range has lasted for less than two years. The index is again rising to the upper limit but to break above it will need a greater catalyst. A Fed Fund rate hike in December would help but may not be enough. In that case it would travel back to the lower limit. The break below 96.485 would be critical for that test.
Major U.S. indices have traded within a range from October 2014 to August 2016, with some differences, before breaking above it, which did not last for long.
Dow Jones Industrial Average (Chart 9), S&P 500 (Chart 10), and NASDAQ Composite (Chart 11) formed a horizontal channel. They broke to upside in mid-July and stayed above it for 7-8 weeks till early-September. Since then they have been trading below it 7-8 weeks.
There are two patterns that gives us some clues about downside targets. First is a bearish ABCD pattern that the major indices are forming over the past 2-3 months. The other is the retracement of the rally from February lows to August highs.
A critical point for DJIA was a weekly close below 17992.21, the low of September 12. On November 4, DJIA closed at 17888.28, thus increasing the odds for a further decline to a level between 17550 and 17430. A close above 18193.68 will make the down side target less likely.
For S&P 500, the critical break point was close below 2119.12 and the downside target is between 2059 and 2047. On November 4, S&P 500 closed at 2085.18 making the downside target relevant. A close above 2133.25 will nullify the pattern.
Technology, Small Cap and Broader Market
NASDAQ Composite is also making a similar pattern and for it the critical break was a close below 5097.80 and the downside target is between 4950 and 4910. Last weekly close was 5046.37. A close above 5206.70 will nullify the down side target.
Russell 2000 (Chart 12) did not break above it prior high in 2016 and, consequently, it did not form the rectangle trading range. Nevertheless its price action is similar to that of others. Its critical break point was 1206.07 and the downside target is between 1165 and 1240. It closed at 1163.44 for the week ending on November 4.
Wilshire 5000 Composite Index (Chart 13) is the broadest market index. Like S&P 500, DJIA and NASDAQ it too made all time high in August and then declined. Its critical break point was 22036.20 and the downside target is near 21200. The composite closed the week at 21594.28, thus making the downside target relevant. A close above 22129.16 will make reaching the down side target less likely in near future.
Dow Transportation and Dow Theory
Under Dow Theory, Dow Jones Industrial Average and Dow Transportation Average need to confirm each other for a reversal in direction. Unlike Industrial, Transports (Chart 14) are moving in the opposite direction, which bodes well for the up trend.
In 2014, Industrials made the high in December after the Transports’ high for the year in November. Industrials made another high in May of 2015 but the Transports did not.
Both made lows in August 2015 and then rose to make intermediate high in November 2015. After that they both declined and made lows in January-February 2016. Industrial did not go below August 2015 low but Transport did, which put question mark over the magnitude and duration of the correction.
In August 2016, Industrials made a new high overcoming the resistance in April. Transport could not overcome the resistance of April and did not make a new high. This created doubts for the up move.
Now that the Industrial are declining, Transports are making another attempt to over come April high of 8149. If they succeed than it increase the odds against the current decline. A break above 8149 will initiate a bullish ABCD pattern. The AB=CD target is 8775.10, which is below 2014 high of 9310.22. The 138.2% and 161.8% targets are 9441.965 and 9853.94 respectively.
On November 4, Transport advanced for the third consecutive days as compared to nine consecutive declining days for S&P 500 and seven consecutive declining days for DJIA. Unless Transport start declining, the down move has limited scope to extend.
Major U.S. indices are declining for the past few weeks. However, they are not doing so with same intensity.
Since September, Dow Jones Industrial Average (top panel Chart 15) is relatively doing better than S&P 500.
NASDAQ Composite (third panel Chart 15) and Russell 2000 (bottom Chart 15) are underperforming the S&P 500.
Russell 2000 is underperforming the NASDAQ Composite (second panel Chart 15).
In a nutshell, it means that for the last 30 days, DJIA is the best performing index followed by S&P 500, NASDAQ and Russell 2000.
In the past one month only two S&P 500 sectors, Utilities and Financials, out of eleven were positive (Fig. 13). Healthcare was the worst performer, which lost -7.55%. including more than -5% in the last two weeks.
During this period, only three sectors – Healthcare, Cyclicals and Energy – underperformed S&P 500. Utilities were +4.25% better than S&P 500 and Financials +3.89%.
Sectors Outperforming S&P 500
Financials’ ratio, XLF:SPY (fifth panel Chart 16), made a double bottom in late June and Financials has been outperforming S&P 500 since then.
Similarly, Financials Services, XLFS (bottom panel Chart 16), is also doing the same.
Technology, XLK (third panel Chart 17) has been outperforming S&P 500 since middle of 2013. It again picked up the pace in April after a brief decline.
Their chart patterns indicate that their current trajectory is still intact.
Sectors Underperforming S&P 500
Consumer Discretionary or Cyclicals, XLY (top panel Chart 16) has been in a down trend compared to S&P 500 after peaking in October 2015.
Consumer Staples, XLP, (second panel Chart 16) has been underperforming S&P 500 since February.
Healthcare sector, XLV (fourth panel Chart 17), has been underperforming the broader index for most of the time since mid 2015 with brief bounces. It is doing even worse after April.
Real Estate, XLRE, (bottom panel Chart 17) generally led the broader index from November 2015 to July 2016. Since then it is mostly underperforming.
The chart pattern of these four sectors are not giving any significant hint of reversal.
Utilities, XLU, (second panel Chart 17), has underperformed S&P 500 from mid-June to October. It has been moving up for the past week.
Sectors Performing Similar to S&P 500
The ratio for Energy, XLE/SPY (third panel Chart 16), bottomed by the end of 2015 and then rose till May 2016. After that Energy is performing about the same as that of S&P 500.
The ratio of Materials and S&P 500, XLB:SPY (fourth panel Chart 16), has been moving since March. Industrial sector, XLI (top panel Chart 17), is doing the same.
Before their current trend, all three sectors were outperforming S&P 500. Odds favor a resumption of that trend.
Markets have been facing many uncertainties at the moment but some of the factors are clearing up. The economy is moving upward but not very convincingly. It can falter in few ways. This is making deciphering FOMC’s next move regarding interest rate still tricky.
Another uncertainty is the outcome of the U.S presidential election. Even though it will resolve in couple of days, its impact on market sentiments and, indirectly on technical is strong.
Third uncertainty is Brexit, which we did not discuss in the this communique, and its impact is still being evaluated. The factor that is clearing up is the corporate earnings situation, which is turning around compared the past few quarters.
Usually, post U.S. presidential election, market rally till the year end. Also, when the ruling party retains control of the White House, market generally advance in the three-month period leading up to the election. This year it did not happen. If the Democrats retain the White House than it will give another impetus to the year-end rally.
On the negative side, Fed is increasingly likely to raise rates in December. Equities generally decline following a rate hike for the news few weeks.
All in all, this means that to navigate this environment, we need to analyze markets more closely. Intermarket analysis provides us with a better handle over the situation. Despite, current forces’ impact, the relative strengths of sectors and asset classes have not diverged a lot from their recent trends.