Large US stocks, as measured by
the Dow Jones Industrial Average, became rated “1” as of December 28,
2018. A rating of 1 means “slightly
resilient” on a scale of 0 to 3, with 0 indicating “least resilient” and 3
indicating “most resilient.” The shift
to 1 from 0 had been expected.
The DJIA had a rating of 0, “least resilient”, since November
30, 2018. This rating indicated that the index would likely decline
dramatically with negative news and would be slow to recover. Negative news of the day did indeed result in
major price declines since the first of December.
This post discusses where US stock
prices may go from here based on the status of CPM’s Market Resilience Indexes
(MRI) as of January 4, 2019. I discuss
three scenarios mentioned in the original post that are relevant to current MRI
conditions. I present background information
on the MRI framework at the end of this post.
Those unfamiliar with the MRI framework should review that information first.
Current
Status of DJIA – January 4, 2019
The current rating of 1 (slightly resilient)
for the DJIA indicates that it has only a slight ability to shake off bad news.
The Micro MRI (the shortest cycle) moved to the up-leg of its cycle and is at
the 31st percentile of levels since 1918. We can reasonably expect it to move through
the 50th percentile and into the upper end of its normal range over
the next several weeks. Absent negative
news, index prices can be expected to follow a similar path.
With only the Micro MRI providing
resilience, the DJIA can be expected to move higher only briefly. When the
Micro MRI comes to the end of its cycle in a few weeks, the DJIA index will again
be rated 0 (least resilient). Without
any positive MRI, it will be most susceptible to negative news and price
declines are likely.
Thus, the most likely outcome
right now is for the bottom of the US stock market to be in a month or so. The bottom will be at a new low. Basically, the current reading indicates that
we are in a bear market rally. This is
described as Scenario #1, below.
Three scenarios are consistent with
the current levels and directions of the MRI.
Scenario #1 (reflects
2008) –
The 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 bear market rally
would be like the one that began in February of 2008. During both February 2008
and now, the market had been sending signals of peak earnings (lower price-to-earnings
but higher price-to-book ratios). The
market ultimately bottomed quite a bit lower in March of 2009. There may not be
the excesses in the financial system that we had in the 2008-9 period, and we
may not experience the same degree of loss that we experienced then. Nonetheless, following the bear market rally,
there could be another decline as the market adjusts to lower earnings growth
rates.
Scenario #2 (reflects
1987) –
The current bear market rally is 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) immediately 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 accelerating an adjustment for lower economic growth that would
otherwise play out over a longer period.
Scenario #3 (reflects
1998) –
A fast recovery to price levels as high or higher than what has been recently
experienced. The recent declines would be seen as being driven by negative
news-of-the-day events occurring at a vulnerable time. This would be like the
decline ending in August of 1998 related to the Long-Term Capital Management
crisis, which was quickly resolved. Economic growth was strong in 1998 just as
it is now. Then, as now, the Macro MRI indicated a negative trend in stock
prices. The LTCM crisis hit at a
vulnerable time. The 2015-2016 period
was similar. The Macro MRI turned
negative in mid-2015, and the yuan devaluation scare produced price declines in
August of 2015. The US stock market
remained vulnerable until mid-2016 and then became “most resilient” through the
beginning of 2018. I have called this a
phantom bear market (link) because the
period lacked resilience, but it did not have a significant negative event to
catalyze a true bear market. During this
period, the Fed cited global weakness and held off raising rates, which seemed
to accelerate the shift to a positive Macro MRI trend.
Update as of January 4, 2019:
- Price gains are, thus far, mild for a bear market rally. Stock prices are modestly off their recent low (evaluating weekly prices), yet the Micro MRI is already at the 31st percentile, indicating that the upside might be less than would be expected if the current level were lower, in the range of, say, the 5th to 10th percentile. This condition is consistent with scenarios #1 and #2.
- Powell, Yellen and Bernanke discussed consideration of global weakness in setting the path for rate hikes (American Economic Association, January 4, 2019). Trade tensions and a deterioration in confidence in Europe and Asia could accelerate a dovish shift in the Fed’s tone. While I do not see the Macro MRI shifting to its up-leg this week or next, this statement is like what was said and done in mid-2016. This would be consistent with scenario #3.
- World Stocks (MXWO) – Rated 1 (slightly resilient), with only the Micro MRI positive and moving higher. As of January 4, 2019, the Micro MRI is at the 64th percentile since 1975. Thus, it is roughly two-thirds of the way through a normal up-leg of its Micro MRI cycle. The peak may be just a few weeks away. While this index does not produce highly reliable signals like the DJIA, it does provide context. This is consistent with scenarios #1 and #2.
- Haven Assets (JPY, CHF, TY1) – This composite series is currently rated 3 (most resilient). That said, the Micro MRI is at a high level (the 86th percentile since 1987) and is likely to peak soon. When it does, there may be a short-term pause in the move higher of the haven assets, possibly during the bear market rally in the stock market. At the moment, it appears that the haven assets will move higher after that pause. This is consistent with scenarios #1 and #2.
Scenario #1 appears most
consistent with the MRI conditions. That
said, some of the qualitative observations (which are not formally considered
in the calculation of the MRI), such as weakening global economic growth
leading to lower Fed rate increases, make scenario #3 more likely.
Of course, the outlook can
change over the next several weeks based on a change in the MRI
conditions. Based on 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 indicators need to be present.
First, the “Exceptional Macro,”
the binary signal, would need to become positive. Yet, it is not close to being present at this
time. If it does appear, it would be most consistent
with Scenario #3.
Second, the Macro MRI itself would
need to turn positive and do so without advanced warning from the Exceptional
Macro. This type of shift in the Macro
MRI occurred in mid-2016 and a few times in the 1990s. At the moment, it does not appear that this
is likely to happen for the DJIA over the next few weeks. If it does turn positive, it would be most
consistent with Scenarios #2 and #3.
Please contact me with any
questions or comments.
Jeffrey Hansen
Background
on The Market Resilience Indexes (MRI)
The CPM Investing framework is
organized around three main MRI that are generated each week for each index
(e.g. DJIA, US 10y Treasury).
- The Macro MRI indicates the long-term trend of resilience and is indicative of the long-term trend in index price. Macro resilience increases and decreases with a cycle lasting several quarters or years. Each weekly reading indicates the level and direction of the long-term trend. The peak of the Macro MRI generally coincides with a peak in index prices. The cycles of the Macro MRI are only somewhat rhythmic; the cycles are often interrupted or truncated.
- The “Exceptional Macro MRI” indicates when the Macro MRI is nearing the bottom of a cycle and is likely to turn positive. The onset of the Exceptional Macro serves as the most sensitive indicator of the bottom of a long-term market cycle.
- The Micro MRI indicates bursts of resilience typically lasting 6 to 24 weeks. The Micro MRI cycles are most apparent in the ups and downs of index prices throughout the year. They can be thought of as normalized price movements.
The MRI are additive. When they
move together in one direction, they reinforce each other, and prices tend to
follow that direction. When they move in opposition to each other, they tend to
cancel each other out, and prices tend to be flat.
To describe the level of the Macro
and Micro 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. A level is
described as, say, the 31st percentile within the historical range
of levels. Its direction is also
important. If it is moving higher (i.e.,
it is on its up-leg cycle), we say it is present and providing resilience. If it is moving down (i.e., it is on its
down-leg), we say it is absent and not providing resilience. From readings of level and direction, we can
estimate the MRI’s likely near-term course.
For example, if a level of a Macro
or a Micro MRI is currently low and moving down, we can guess that it will not
move down much longer. As it nears the 1st percentile, the very lowest level of
its historical range, we can expect the MRI to shift to the positive leg of its
cycle and move higher. The Macro and Micro MRI are analog signals; levels move
continuously and in a very general sine wave.
The Exceptional Macro is a binary
signal. It is either present or
not. When it is present, it can
overwhelm the analog Macro and Micro MRI to produce price gains even when the
Macro and Micro MRI are absent.
The ratings are defined by the
number of positive MRI:
3 = Most resilient
2 = Moderately resilient
1 = Slightly resilient
0 = Least resilient
If all three MRI for an index are providing
resilience, it is rated 3, “most resilient,” and prices may decline in response
to bad news, but prices recover quicker and more completely.
When none are providing resilience,
it is rated “least resilient” and bad news produces bigger declines with slow
and incomplete price 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. stocks, bonds, and cash) rated most resilient and to
avoid those rated least resilient. Trades based on MRI levels and directions
are more reliable than trades based on actual price levels and directions.
Note: For purposes of estimating
stock market resilience, the Dow Jones Industrial Average is superior to other
major indexes. It has a 100-year
history, has fewer constituents and indicates inflection points more
distinctly, and has less interest rate sensitivity and commodity sensitivity
than the Russell 1000 and the S&P 500.
Thus, while it sounds very old school to use the DJIA, it produces reliable
signals and justifies the focus. We do
track and evaluate other indexes for context and confirmation.
