The DJIA continues to be rated “most vulnerable” with a
rating of “0.” The scale is 0 to 3, with 3 indicating “most resilient.” The DJIA achieved the most vulnerable rating on November 30, 2018. This rating indicates that the index would
likely decline with negative news and would recover slowly. Negative news of the day resulted in major
price declines since the first of December. This post discusses where prices
may go from here based on the status of CPM’s Market Resilience Indexes (MRI).
The CPM Investing framework consists of three main MRI for
each index (e.g. DJIA, US 10y Treasury).
The Macro MRI indicates the long-term trend in index price. The peak of the Macro MRI coincides
(generally) with the peak in index prices.
The Macro MRI indicates the pricing cycles of resilience lasting several
quarters or years.
The Exceptional Macro MRI indicates when the Macro MRI is
nearing a bottom of its cycle and is therefore likely to turn positive. The onset of the Exceptional Macro serves as
the most sensitive indicator of the bottom of a market.
The Micro MRI indicates the bursts of resilience lasting typically
6 to 24 weeks, depending on environment and asset class. The Micro MRI cycles are most easily seen in the
ups and downs of index prices throughout the year.
The MRI are additive.
When they move together, all moving higher, for example, they reinforce
each other and prices tend to follow that direction. When they move in opposition to each other, some
moving up and some moving down, they tend to cancel each other out, and prices
tend to be flat.
To describe the current level of an MRI, we indicate its
percentile level within all its weekly levels since the inception of the index. For example, the DJIA has over 5200 weeks of
history since 1918. The current level is
described as the 10th percentile in its historical range. From that reading, we can see that its level
is toward the lowest level of its historical range. If the level is currently moving down, we can
guess that it will not move down much further.
When it is at or near the 1st percentile, it is at the very
lowest level of its historical range. Since
the levels are mean reverting, we generally expect the MRI to shift to the positive
leg of the cycle and move higher. This
cycle is relatively consistent over time.
When the Macro and Micro MRI are moving higher (in the
positive legs of their cycles), we say they are present and providing resilience. If the Exceptional Macro is also present, the
index has a rating of 3; all three MRI are providing resilience. When bad news occurs, it may drive prices
down. But the strong resilience of the
market will generally cause prices to recover quickly.
When none are moving higher, the market has a rating of
0. During these periods, bad news
produces bigger declines and slow and incomplete recoveries.
The MRI levels and directions at a given time for different
asset classes can help us position portfolios to favor the asset classes (e.g.
stock, bonds, and cash) most likely to be resilient and to avoid those most
likely to be vulnerable. For professional investors, this information can add a
timeliness element to their existing investment activities.
With its current rating of 0, the DJIA has little ability to
shake off bad news. That said, the Micro
MRI (the shortest cycle) is at a low level (10th percentile since
1918) and is therefore poised to turn positive.
This implies the market is likely to soon display short-term resilience that
could move the DJIA price higher from its current level. An absence of bad news or a positive catalyst
is often needed to initiate an up-leg of the Micro MRI cycle.
Yet, when only the Micro is providing resilience, the index price
will generally move higher only briefly.
Based on general market behavior over the last 100 years, for this brief
move higher to be the beginning of a long-term trend higher, one or both of two
conditions would need to be true. First,
the Exceptional Macro would need to be present.
It is not close to being present for the DJIA. Second, the Macro MRI
itself would need to turn positive without the advanced warning made by the
Exceptional Macro. This is not likely to
happen for the DJIA over the next several weeks. Thus, I believe the bottom of the US Stock market
is likely to be several months away.
Other MRI-related observations about the current environment:
- US 10y Treasury Future – It is currently rated 2 (somewhat resilient), with its Micro and Exceptional Macro being positive. The Macro (long-term) MRI is at the 3rd percentile – a very low level – in the historical range established since 1983 and is close to moving into its up-leg. The important Exceptional Macro is positive and thus foreshadows a shift to a positive Macro MRI. When the Macro MRI does turn positive, it would signal the bond prices are resilient and likely to move higher.
- Dollar Index (DXY) – new rating of 1 (somewhat vulnerable to declines) last week, down from a rating of 3 the week before. This is a rapid shift toward greater vulnerability and suggests a weaker dollar over the next several weeks.
- US 2y Yield – shifted to a rating of 0 (most vulnerable to declines) on 11/30/2018. The Macro MRI abruptly turned negative on that date, having been at the 100th percentile (since 1976), obviously an extremely high level. In contrast, the Micro MRI is at a very low level for this series – corresponding to the 2nd percentile over the same time period. While the Micro MRI is likely to become positive in the next few weeks and provide temporary support for the 2-year yield level, at the moment, the longer-term (Macro) trend for the 2-year is for lower yields.
- US 10y Yield – shifted to a rating of 0 (most vulnerable to declines) last Friday. The Macro MRI abruptly turned negative last week (12/14/2018). While the Micro is at a low level and will likely soon turn positive, it will then be rated only a 1, “somewhat vulnerable to declines.”
- The following stock market indexes have ratings of 0 (most vulnerable to decline): UK Stocks, Europe stocks, Japan stocks, Emerging market stocks (MXEF), Shanghai Composite. Many of these have Micro MRI that are toward the lower ends of their historical ranges and could begin to experience a bear-market rally. Yet, the Macro MRI is clearly moving in a negative direction from historically high levels, reinforcing the view that these rallies will be brief. The Exceptional Macro is not close to being present for any of these indexes. The exception to this generalization is that the Shanghai Composite seems a bit closer than the others to shifting to a more positive long-term trend. Thus, the mid-term outlook for global stocks is quite negative.
- Regarding inflation concerns, the relative leadership of global inflation-linked bonds vs. global nominal bonds had called for inflation-linked bonds to be favored (with a rating of 3, most resilient) as recently as November 23, 2018. Now, inflation-linked bonds are less resilient than nominal bonds (the relative leadership series is rated 1, meaning avoid inflation-linked bonds and favor nominal bonds). By this measure, a deterioration in inflation expectations has happened quickly.
Many of these changes have occurred quickly compared to
their historical norms. This may be an
additional negative sign for stock markets in general. Recent negative news has come at a
particularly vulnerable time and has sent prices lower.
Thus, stock prices globally are likely to remain “most vulnerable
to declines,” with a rating of 0, or “somewhat vulnerable to declines,” with a
rating of 1, for several months. If
general historical precedents based on 100 years of history for the DJIA hold
true for the current mix of MRI, any rally driven by a positive Micro MRI will
be quickly followed by lower lows.
While this is the most common scenario (identified as scenario
#1 below), there are two scenarios in which the market has begun a long-term
trend higher from a configuration of MRI levels and directions much like those we
are now experiencing. All three of
these scenarios have levels and directions of MRI like the current state for
the DJIA.
Scenario #1 – The upcoming bear-market rally would move
prices higher but not establish new highs.
This would be followed by dramatically lower lows. The recent declines would be seen as an
indicator of coming slower economic growth (the market has been signaling peak
earnings for the last eleven months). The bear-market rally would be like the
one that began in February of 2008. During
February 2008 and now, the market had been sending signals of peak earnings
(lower PER but higher PBR measures). In
the earlier period, the market ultimately bottomed quite a bit lower in March
of 2009. We may not experience the same
degree of loss as that was experienced in the 2008-2009 period, but following
the bear-market rally there could be another decline as the market adjusts gradually
over several months to lower growth rates.
Scenario #2 – The upcoming bear-market rally is absent or muted
but a longer-term positive price trend follows.
The recent declines would ultimately be seen as a rapid, large-scale
adjustment of valuations similar to the price declines of October 1987. There was not a strong rally (bear or
otherwise) after the October 1987 decline but the decline did not foreshadow further
deterioration in the real economy. Economic
growth was strong pre-October-1987 just as it is now. In this scenario, the negative news catalysts
for the price change (trade tensions, threats to Fed Independence, and general
Washington chaos) might have the effect of bringing forward in time an adjustment
for lower economic growth that would otherwise play out over a longer period
(as in scenario #1).
Scenario #3 – A fast recovery to price levels higher than
what has been recently experienced. The
recent declines would be seen as being driven by unfortunately-timed
news-of-the-day events. This would be like the decline ending in August of 1998
related to the Long-Term Capital Management crisis, which was then quickly
resolved. But the DJIA price trend was
much stronger in 1998 than it is today. Economic
growth was strong in 1998 just as it is now.
In the meantime, CPM research indicates that the prudent
positioning of a multi-asset portfolio is to favor bonds and cash. Avoid stocks.
The recent sharp declines may not have ended yet. The algorithms for our more active portfolios
will likely attempt to take advantage of any bear-market rally. The algorithms for our less active portfolios
are more likely to sit out the bear-market rally.
Please contact CPM Investing with any questions or
comments.
