TradingEdge for Jul 16 - A Sharpe Trend, More Divergences, Cautious Corn

Jason Goepfert
2021-07-16
This week saw some wobble in what has been a historically positive risk-adjusted rally in the S&P 500. There is a lot of rotation under the surface, with too-few stocks above their 50-day averages, and low correlations among sectors. Several of them have given recent reversal signals. Some commodities still look vulernable especially if low exposure to the dollar continues to reverse.

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.

STOCKS

For investors, nirvana is a market showing steady and impressive gains without much risk. That pretty much sums up the past year. Using a version of the Sharpe Ratio, the S&P 500 has seen the best risk-adjusted returns since late 2017 and ranking among the best ever.

Methodologies for calculating the ratio can vary, and using it as a measure of portfolio managers' acumen is subject to fierce debate. It's still a handy way to determine just how ideal market conditions have been for investors.

For the S&P, its Sharpe Ratio is just now rolling over from an extremely high level.

After other times the ratio got as high as it recently was and started to roll over, the S&P saw some weakness over the medium-term. 

Over the next three months, the S&P showed a negative average return and poor risk/reward ratio. Across all medium- to long-term time frames, returns were below average. 

Looking at other impressive but ebbing risk-adjusted rallies in the S&P and their impact on sectors, Energy, Utilities, and Health Care tended to hold up the best.

HEDGE FUNDS TRYING TO TAKE ADVANTAGE OF THAT TREND

We already know that small options traders, among many others, have been jumping once again into speculative trades. Now we can add hedge funds to the mix.

The latest estimate of Hedge Fund Exposure shows that funds are nearly 40% net long stocks, a quick rise from almost being flat a month ago. Over the past few years, when it has climbed this high, the S&P ended up giving any further gains back, though it took a long time to play out during the momentum market immediately before the pandemic crash.

After any day since 2003 when Exposure was below zero, the S&P 500 returned an annualized 15.2%, versus only 1.4% when Exposure was above 25% as it is now.

If we look at what happened after the first reading above 35% in at least six months, medium-term returns were unimpressive. Out of ten prior signals, only two (November 2006 and November 2010) managed to show large and sustained gains over the next 1-3 months. Up to three months later, risk was higher than reward.

HARDER TO TRADE STOCKS THAN INDEXES

The most-benchmarked index in the world has now doubled from its pandemic low. 

Going back to 1928, this is the 2nd-fastest doubling off of a multi-year low, eclipsed only by a breathtaking rally in 1932. These are the only two times it managed to double in under 400 trading sessions. Other times when the S&P doubled from a low, it struggled a bit over the short- to medium-term.

The double is due in part to a remarkable run over the past three weeks. The S&P closed at a record high on 10 out of the past 15 sessions for the first time in more than a year. The other time the index enjoyed a run like this was just before the pandemic struck. Even without that outlier, the S&P did have some trouble holding onto its momentum over the medium-term. 

The great run in the index is still hiding some issues under the surface, as there's the issue with relatively few stocks managing to climb above their 50-day moving averages. It hasn't been able to jump above 60% for weeks. We've been highlighting this since late June, and clearly, it hasn't mattered yet. 

These kinds of clusters are scarce. The last time the S&P saw a flurry of new highs with fewer than 60% of issues above their 50-day averages was in 1999. Even going back to 1928, this is an extreme outlier.

Stocks have been generating "extremely rare events" for months now, and still, the indexes are sitting at or near new highs, so the oddities haven't mattered one whit.

CYCLICAL STOCKS ARE UNDER-PERFORMING

Dean notes that the S&P 500 has now recorded ten new 252-day highs in the last month as a basket of cyclical groups has failed to record a single new high. That's never happened in the 60+ year history of the data, not even during the height of the internet bubble.

The last high for any cyclical group occurred on 6/4/21 when financials managed to do so.

The cyclical group new high count model identifies when economically sensitive groups fail to confirm new highs in the broad market as measured by the S&P 500. While the sample size is small, the results are weak across almost all timeframes.

Since the signal includes a momentum component, it won't trigger unless the S&P 500 starts to stumble in the days ahead.

SMALL-CAPS SWINGING BY THEMSELVES

Investors are having a tough time keeping a grasp on things. Stock indexes have been levitating at record highs, but there is a lot of tumult under the surface.

Some of the rotation has been vicious. Among sectors and factors, none is more evident than between Small-Cap stocks and Growth. Over the past year, the correlation between those two factors has plunged to the lowest since 1933.

To a large extent, Growth = Technology, and we can see a similar plunge in that correlation. The rolling 1-year correlation between Small-Caps and Technology has just nosedived and is nearing its prior recent low from the end of 2017.

As for what it means for future returns, for the broader market, the answer was, "not much." Small-Cap stocks tended to do better, with no losses over the next 3 years. Technology didn't do terribly, but returns tended to be lower.

Those differences in future returns mean that Small-Cap stocks tended to do relatively better than Technology, and we can see that in the table below.

There were a couple of big misses, including the most recent signal from 2017. It also didn't work in late 1989 as the U.S. was heading into a recession. Other than those major exceptions, Small-Caps mostly outperformed across most time frames.

A big part of whether Small-Caps can regain and retain outperformance versus Technology may lie with the path of 10-year Treasury yields. Over the past 20 years, in particular, the two have closely followed each other.

STOCKS AND SECTORS - GLOBAL STOCKS

Earlier in the week, Dean updated his absolute and relative trend following indicators for domestic and international ETFs.

The technology and consumer discretionary sectors registered multiple relative highs last week. In particular, the breakout in AMZN propelled the discretionary group. Short-term price momentum in technology remains strong, with the sector closing above its 10-day moving average for 25 consecutive days.

Interestingly, the equal-weighted data from the technology and consumer discretionary sectors did not confirm the trends in the cap-weighted versions.

Outside of the U.S., the percentage of countries with a positive relative trend score versus the S&P 500 decreased to a level that suggests negative returns for regions around the globe.  

When the percentage of countries outperforming the S&P 500 on a rolling 21-day basis falls to a low level and the S&P 500 itself is at or near a high, all tend to suffer.

STOCKS AND SECTORS - SMALL-CAP VALUE

Jay pointed out that in the past 5 to 10 years, there is little argument that the categories of large-cap, growth, momentum, and technology have ruled the roost. The Nasdaq 100 has been a superstar among stock indexes. 

The stock market's history definitively shows that nothing ever lags - or leads - forever. So, let's focus on trying to develop a reasonable way to address this. We will use the Russell 2000 Value Index (small-cap value stocks) and Russell 1000 Growth Index (large-cap growth stocks) for testing purposes.

These indexes are:

  1. Broadly based
  2. Very different in terms of the types of stocks they hold
  3. Have data going back to 1979

Given the massive outperformance of large-cap growth stocks in recent years, many investors may be surprised to learn that small-cap value has outperformed over the past 42.5 years. To take advantage of the relationship between the two, we will look at a 10-month exponential moving average of the ratio of small-cap value to large-cap growth.

Then we will apply the following rules:

  • If C > 0, it suggests that small-cap value is "leading," so we will hold the Russell 2000 Value Index
  • If C < 0, it suggests that large-cap growth is "leading," so we will hold the Russell 1000 Growth Index
  • As a baseline, we will also track a Buy/Hold/Rebalance strategy that splits money equally between the two indexes and rebalances to a 50/50 split at the end of each year

The chart below displays the cumulative growth for our "Switch" strategy versus the Buy/Hold/Rebalance strategy.

Small-cap value shares are still leading, but the difference has narrowed and is close to switching back to large-cap growth. Investors can easily follow this strategy using ETFs like IJS for small-cap value and QQQ for large-cap growth.

STOCKS AND SECTORS - BIOTECH, ENERGY, AND JAPAN

Jay suggests that the application of seasonal trends to a trading regimen is often misunderstood. Some try to assign an almost mystical power to seasonality, while others dismiss it completely. The proper approach (in one author's opinion) is to view seasonality simply as one more tool - aka, moving averages, RSI, stochastics, etc. - to help determine where best to allocate capital at a given point in time.

A security that shows a fantastically favorably (or unfavorable) seasonal pattern is NEVER guaranteed to rally (or decline) the "next time around." 

There are a handful of domestic U.S. sectors with a currently favorable seasonal outlook. Ticker XLP (Consumer Staples Select Sector SPDR Fund) is generally considered a "defensive" sector. The good news, for now, is that it tends to hold up well during the June-Oct period that often trips up a lot of sectors. 

Tickers IYR (iShares U.S. Real Estate ETF), XHB (SPDR S&P Homebuilders ETF), and IBB (iShares Biotechnology ETF) all have favorable seasonality at the moment - but traders should keep a close on the exits.

The "Bad News" for U.S. sectors is heavily focused on the energy and metals, and mining sectors, which historically tend to struggle during the Jun-Oct period. Note the seasonal outlook in the chart below for ticker XLE (Energy Select Sector SPDR Fund).

On a seasonal basis only, many single-country indexes tend to show extreme weakness during the Jun-Oct period. As always, there is no guarantee that that will be the case in 2021. But it is worth being aware of, as some appear to be "running out of runway." See the charts below for ticker EWJ (iShares MSCI Japan ETF).

The most important thing to remember about seasonal trends is that no trend is guaranteed to work this time. The best analogy is the weatherman. While they are (understatement alert) never guaranteed to be right in their forecast, you still want the best information available. 

STOCKS AND SECTORS - OIL & GAS

The S&P 1500 Oil & Gas Exploration & Production sub-industry group registered a 252-day high to 21-Day low reverse-down sell signal at the close of trading on Thursday, according to Dean.

The reverse-down signal identifies when a stock, index, or ETF registers a 252-day high and then reverses lower and registers a 21-day low in 10 days or fewer. 

If we look at the short signals since 1989, the percent profitable was 73%, and the profit factor was a healthy 11.6. The signals also preceded below-average returns in the S&P over the short-term and terrible returns in crude oil over the next month.

Jay looked at these odds in crude oil and showed how a trader could use a bear call credit spread to potentially made a high-probability return of 9% in a matter of weeks...as long as the trader remains highly vigilant of the risk in such a position should oil do what it's not supposed to.

Dean also noted that the energy sector weakened considerably, and new lows expanded in a meaningful way. According to our calculation, the percentage of S&P 500 Energy sector members registering a 21-day low surged to 82%, a level not seen since September 2020.

When there was a surge in one-month lows within about a month of a 52-week high in the Energy sector, future returns were weak shorter-term but strong and consistent longer-term.



COMMODITIES


Jay took a deep dive on corn and its prospects for the coming months.

The Sentimentrader Backtest Engine just generated a new signal for Corn. This signal occurs when the 100-day average for Corn Optix drops from above to below 72. The new signal and previous signals appear in the screenshot below.

As you can see in the table below, this signal has generally - but importantly, not always - been a precursor of some abysmal results for Corn in the year ahead (note that the 2007 signal witnessed a decline for Corn 3 months after the signal, but was followed by a rip-roaring rally in the next 9 months - which, for the record, set the stage for the 2008 collapse).

Combined with a weak seasonal period, risk looks high in corn. Jay updated a potential option trade from earlier to take advantage of that view.

Corn could also be at risk if the dollar rallies. As noted above, hedge funds seem intent to get exposure to stocks. For the U.S. dollar, it's a different story. Estimated Hedge Fund Exposure in the dollar is likewise extremely low

Low exposure has preceded positive returns for the buck. Gold returned an annualized -1.0% when Exposure in the dollar was below -30%.

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