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Weekly Wrap for Oct 8 - The Ends of Momentum and Risk-On Behavior; Inflation Problems:
This week, stocks finally saw an end to many streaks of momentum and risk-on behavior. Some sentiment indicators registered pessimism for the first time in over a year. The S&P 500 suffered its longest pullback in over 200 days. High inflation remains a concern, and emerging market central banks are raising rates.
Bottom Line:
STOCKS: Weak buy
The speculative frenzy in February is wrung out. There are some signs of pessimism, but the most compelling data show that buyers consistently tend to return once the first signs of extreme momentum end, especially as we head into a seasonally positive time of year. See the Outlook & Allocations page for more. BONDS: Hold
Various parts of the market got hit in March, with the lowest Bond Optimism Index we usually see during healthy environments. Bond prices have modest recovered and there is no edge among the data we follow. GOLD: Hold
Gold and miners were rejected after trying to recover above their 200-day averages in May. Lately, some medium-term (not long-term) oversold extremes in breadth measures among miners have triggered.
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Smart / Dumb Money Confidence
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Smart Money Confidence: 63%
Dumb Money Confidence: 40%
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Risk Levels
Stocks Short-Term
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Stocks Medium-Term
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Bonds
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Crude Oil
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Gold
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Agriculture
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Research
By Jason Goepfert
BOTTOM LINE
This week, stocks finally saw an end to many streaks of momentum and risk-on behavior. Some sentiment indicators registered pessimism for the first time in over a year. The S&P 500 suffered its longest pullback in over 200 days. High inflation remains a concern, and emerging market central banks are raising rates.
FORECAST / TIMEFRAME
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The goal of the Weekly Wrap is to summarize our recent research. Some of it includes premium content (underlined links), but we're highlighting the key focus of the research for all. Sometimes there is a lot to digest, with this summary meant to highlight the highest conviction ideas we discussed. Tags will show any symbols and time frames related to the research.
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For the first time in over a year, investors have a risk-off mentality and show signs of widespread pessimism.
It's not extreme in most cases, and Friday's rebound puts a dent in the argument, but last week showed the first real signs of concern since the spring of 2020.
The Risk-On / Risk-Off Indicator looks at more than 20 indicators and calculates the percentage displaying risk-on or risk-off behavior. You can see them individually by going to Spotlights > Spotlight on Sentiment. The two other times that the indicator tipped into risk-off territory over the past year, buying pressure came in immediately. Last week was the first time that didn't happen.
That ended the longest streak of the Risk-On / Risk-Off Indicator above 50% on consecutive days.
After other long streaks of risk-on behavior finally ended, it didn't prove to be a negative sign for stocks. As we repeat often, momentum (and optimistic behavior) does not die easily. While the S&P 500 suffered some short-term volatility, it consistently rebounded in the months ahead. Over the next 6-12 months, there was only a single slight loss.
There was a consistent return of risk appetite among other markets. The Nasdaq 100 showed the best returns, with investors shunning gold.
Composite sentiment indicators tend to mirror one other, so it's not a big surprise that others are showing similar behavior. The spread between Smart Money and Dumb Money Confidence has now crossed above +25% for the first time in 17 months. The spread will rise as "smart money" indicators show rising confidence in a rally combined with declining "dumb money" indicators showing reduced confidence.
That ends the longest streak below 25% since we began calculating this near the end of 1998. The only time investors went longer without even a hint of pessimism was the one that ended in August 2017.
HARD TO FIND A LOSER
This year marked one of the few in four decades when at least 80% of stocks sported a positive YTD return through the third quarter. Over that span, only six years accomplished this, four of which have been since the global financial crisis in 2008.
It's also been a year with some of the best gains. The median stock in the index returned 16% through Q3. That ties for 7th place among all years since 1980.
The five other times when more than 80% of stocks showed a positive return through the end of September, the S&P 500 index itself continued to rise through year-end each time, averaging an impressive return of +6.6%. Two of those ended up giving back the gains and then some in the months after that, though.
Looking at the (admittedly tiny) sample size visually, we can see the consistent tendency to see rising prices over the next three months at least before the index suffered chopper trading activity. The only standout was 1989, which barely showed a positive return over the next few months.
THE FIRST 23-DAY PULLBACK
Last August, the S&P 500 did what was unthinkable just a few months prior - it broke out to a new all-time high. Soon after, stocks saw a bit of a blow-off peak and the S&P didn't regain its highs until November. And it hasn't looked back since. The most protracted pullback that investors suffered was 22 days in June. Until now.
This ends a near-record run with investors not having to suffer more than 22 days without seeing a new multi-year high (not considering bear markets). The only period that exceeded our current run, and that was just barely, ended in February 1955.
For what it's worth, buyers came in immediately after that streak ended, setting a new high the next day, and pushed the S&P 500 higher by a couple of percentage points over the next month. It did suffer some longer pullbacks after that but enjoyed double-digit gains within six months.
That was more the rule than the exception. After other long streaks without a 23-day pullback finally ended, the S&P rebounded during the next three months every time.
Over the following three months, risk was very low relative to reward. Only 2 out of the 19 signals saw more than a further 5% decline at any point within that time frame, while a whopping 14 of them saw more than a 5% gain at the best point.
DEALER BUYING?
Gamma exposure refers to the sensitivity of existing options contracts to changes in the underlying price of the S&P 500. Jay showed the chart below, which takes an extra step and shows Gamma Exposure relative to the market capitalization of U.S. stocks. The higher the level, the more potential selling pressure exists. This value is displayed in thousandths of a percent.
Note that signals often tend to occur in clusters, and lately, it's been at a very low, or even negative, value. Such low levels have tended to precede rallies in the S&P 500.
Note the high Win Rates - particularly for 1 Month and out - and the strong Median Returns for all timeframes.
HIGH VALUATIONS + HIGH INFLATION = DANGER
Historically, periods of low price-to-earnings (P/E) ratios have been followed by generally higher stock prices and vice versa. Likewise, periods of moderate price inflation tend to be accompanied by rising stock prices, while periods of significant inflation or deflation tend to be accompanied by declining stock prices.
Jay pointed out that what we have at the moment is the worst of both worlds - high P/E ratios AND high inflation.
To demonstrate, he created a custom index combining both valuation and inflation, calling it the Valuation:Inflation Indicator (VI). The VI is calculated at the end of each month.
The chart below displays the historical values for the VI Indicator. The blue line is set at a value of 60, which we will use in a moment as an important point of demarcation.
Now let's look at the performance of the Dow Jones Industrial Average ONLY during those months when the VI ended the previous month AT OR ABOVE 60.
The chart below displays the growth of $1 invested in the Dow ONLY if the VI end the previous month AT OR ABOVE 60, using a logarithmic scale.
The total cumulative loss on a percentage basis was (-73.4%).
Since the latest readings are well above our cutoff level of 60, does this mean that stocks are "doomed" to perform poorly from here? Not necessarily. Stocks showed a gain during 42% of previous Unfavorable periods. Nevertheless, overall market performance has been abysmal during Unfavorable periods, registering a net loss of -73.4%. High valuations and high inflation remain a longer-term worry for stocks.
STOCKS AND SECTORS - OVERSEAS INDEXES
Dean updated his absolute and relative trend following indicators for domestic and international ETFs.
The energy sector continued to improve with trend score gains on an absolute and relative basis in an overall soft week for the broad market. I would also add that the group registered a new relative high on 3/5 days.
The financial and communication services sectors are worth noting as both showed improvement on a relative basis, especially the latter.
The gains in the reopening groups came at the expense of growth-oriented sectors like technology and health care.
The percentage of countries with a positive relative trend score versus the S&P 500 declined slightly on a w/w basis. The current level continues to suggest an unfavorable environment for the MSCI ACWI World Index ex USA.
The percentage of countries with a relative trend score of -10 versus the S&P 500 decreased across all regions on a w/w basis. So, we see improvement off the worst possible level. Still, most countries continue to maintain an unfavorable performance profile versus the S&P 500.
STOCKS AND SECTORS - EMERGING MARKETS
Central banks around the globe have begun the process of normalizing interest rates after one of the most profound easing cycles in history. Dean showed that emerging markets are leading the charge as inflationary pressures are driving the shift in monetary policy. Remember, inflation acts as a tax on the poor and impacts corporate margins for specific industries that have no pricing power.
The following chart contains an indicator that measures the percentage of emerging market countries with increasing policy rates. The calculation uses 13 essential economies, including the BRICs. The indicator touched 50% in August before dropping in September due to a rate cut in Turkey. Annualized returns diminish when the percentage increases above 50% and turn markedly negative when above 60%.
Never fight the fed is one of the golden rules of investing. When central banks act, take note. As the data shows, a broad-based allocation to emerging market stocks looks unfavorable until EM central banks decide to change course.
STOCKS AND SECTORS - CONSUMER STAPLES
Consumer Staples stocks rarely get investors excited. Now is definitely one of those times.
Thanks to lagging stock prices and shrinking market cap while other sectors gain, Staples' share of the S&P 500 has shrunk below 6% for only the 2nd time in 30 years, according to Bloomberg calculations. That happened to be in early 2000 as stocks were peaking and Staples went on to massive outperformance over the next couple of years.
So many of the stocks have been forgotten, for so long, that the McClellan Summation Index for the sector has dropped below -500, enough to consider it deeply oversold. Curiously, this triggered even though the sector itself has been holding above a rising 200-day moving average.
The total return on Staples when it was trading above a rising 200-day moving average and the Summation Index fell below -500 was positive across all time frames, with especially positive returns over the next six months. Out of the 18 signals, 16 showed a positive return over that time frame.
Over the next three months, only 3 dates led to a maximum decline greater than -5% while 10 of them preceded a maximum gain greater than +5%. Staples are now entering a very positive time of the year, and options traders have been fairly aggressively placing bets against the sector. While correlations among Staples stocks aren't indicating panic conditions, and corporate insider activity is tepid at best, the "oversold in an uptrend" setup is compelling.
Related to the inflation data above, Jay noted that inflation is an enemy of the bond market. When a bond buyer buys a bond, they typically lock in a rate of return based on the amount of interest the bond pays annually. If inflation rises while that bond is held, the purchasing power of the future interest payments is reduced, as is the value of that bond.
The purpose of this piece is not to argue the pros and cons of TIPs. The purpose of this piece is to test a theory and one specific approach in attempting to maximize bond returns regardless of inflation.
For our initial test, we will use total return data for IEF ( iShares 7-10 Year Treasury Bond ETF ) and STIP (iShares 0-5 Year TIPS Bond ETF).
The chart below displays the 5-year Treasury Constant Maturity Rate minus the 5-year breakeven inflation rate.
In theory, straight treasuries are more attractive when the spread is positive, and TIPs are more attractive when it is negative. For the next test, we will also consider total return data for ticker STIP starting the week ending 12/3/2010 (first week of available data).
We will test the following "Switching Strategy":
- IF the spread is > 0.1 THEN hold IEF
- IF the spread is <= 0.1 THEN hold STIP
We will also compare the return to buying and holding ticker IEF. The chart below displays the comparative results.
This little experiment is by no means the "be all, end all" of investment strategies. Likewise, a 10-year test may not capture all environments that a bond strategy might encounter over time.
Still, compared to buying-and-holding IEF, the "Switch Strategy" did achieve:
- Higher returns
- More consistently
- With less volatility
- With lower drawdowns
The relative merits of this one example strategy aside, the real bottom line is that bond investors may be wise to watch interest rates versus the inflation rate breakeven price.
Jay noted that seasonal trends are NOT predictions or forecasts. They merely show when a given tradable has tended to trend in a particular direction in the past.
In using seasonal trends myself, I focus on the major trends rather than on every little squiggle in the Annual Seasonal Trend chart for a given security or commodity.
Basic Rules for Using Seasonal Trends:
- NEVER assume a given seasonal trend will play out as expected "this time"
- Use ST as a "weight of the evidence" factor, NOT as a standalone indicator
- IF you are bullish AND ST is bullish (or if you are bearish and ST is bearish), it is a time to aggressively press your advantage (while still respecting your own position sizing and risk management rules)
- IF you are bullish AND ST is bearish (or if you are bearish and ST is bullish), you can still enter a bullish trade, BUT be more mindful of risk (i.e., perhaps commit less capital and/or use a tighter stop)
He looked at a number of these right now, including energies, metals, and currencies. Many traders are surprised to learn that foreign currencies also have a seasonal element to their price movements. At the moment, several currencies are entering periods of seasonal weakness. It should be noted that during this time of year:
- When they go up, they tend to go up a little
- But when they go down, they tend to go down a lot
Active Studies
| Time Frame | Bullish | Bearish | | Short-Term | 0 | 0 | | Medium-Term | 7 | 0 | | Long-Term | 11 | 5 |
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Indicators at Extremes
Portfolio
| Position | Description | Weight % | Added / Reduced | Date | | Stocks | RSP | 10.5 | Added 6.4% | 2021-10-01 | | Bonds | 23.9% BND, 6.9% SCHP | 31.5 | Reduced 7.1% | 2021-05-19 | | Commodities | GCC | 2.6 | Reduced 2.1%
| 2020-09-04 | | Precious Metals | GDX | 4.2 | Reduced 4.2% | 2021-05-19 | | Special Situations | 9.8% KWEB, 4.7% XLE, 2.9% PSCE | 17.3 | Added 9.78% | 2021-10-01 | | Cash | | 34.0 | | |
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Updates (Changes made today are underlined)
Much of our momentum and trend work has remained positive for several months, with some scattered exceptions. Almost all sentiment-related work has shown a poor risk/reward ratio for stocks, especially as speculation drove to record highs in exuberance in February. Much of that has worn off, and most of our models are back toward neutral levels. There isn't much to be excited about here. The same goes for bonds and even gold. Gold has been performing well lately and is back above long-term trend lines. The issue is that it has a poor record of holding onto gains when attempting a long-term trend change like this, so we'll take a wait-and-see approach. Momentum has ebbed quickly in recent weeks, and nearing oversold levels in some indicators. This can be a dangerous area, with a lot of short-term volatility, but we'd be more inclined to add medium- to long-term exposure rather than sell on much more of a decline, thanks to already rock-bottom exposure. Other areas look more attractive, including some overseas markets. RETURN YTD: 10.0% 2020: 8.1%, 2019: 12.6%, 2018: 0.6%, 2017: 3.8%, 2016: 17.1%, 2015: 9.2%, 2014: 14.5%, 2013: 2.2%, 2012: 10.8%, 2011: 16.5%, 2010: 15.3%, 2009: 23.9%, 2008: 16.2%, 2007: 7.8%
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Phase Table
Ranks
Sentiment Around The World
Optimism Index Thumbnails
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Sector ETF's - 10-Day Moving Average
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Country ETF's - 10-Day Moving Average
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Bond ETF's - 10-Day Moving Average
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Currency ETF's - 5-Day Moving Average
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Commodity ETF's - 5-Day Moving Average
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