Weekly Note - April 29, 2020

This is likely to be the last week of the “Wait & Prepare” season. At the end of this week, we are likely to shift to a Harvest season.

I continue to believe a less aggressive stance for your account is appropriate for the reasons reviewed below.

Market Context

As of today (April 29), the relief rally is continuing to push stock prices higher. I do not expect the recent pace of price appreciation to continue for long. As you know, last week I gave the first-ever guidance to reduce account aggressiveness by raising cash or switching to a less aggressive model portfolio. While as of today, reducing account aggressiveness has caused us to forego some returns, I continue to believe the less aggressive stance is appropriate.

Over the next week or so, investor sentiment will likely become more negative than the optimism we currently see in the stock market. As you may recall, I have mentioned that I would issue alerts, if needed, outside of the regular midweek communication schedule. I may take this step over the next weeks, but I believe the step of proactively reducing account aggressiveness will give us some flexibility around that alert and the implementation of guidance at that time.

The comments below describe the reasons for the special guidance issued last week. No new special guidance is provided below.

The Micro MRI is Moving into the Upper End of Its Cycle

As of last Friday, the cycle of short-term resilience, the Micro MRI, was at the 63rd percentile of levels over the last 100 years. It was at an extremely low level (9th percentile) just six weeks ago. A key question is: At what level does the Micro MRI for the DJIA stop moving higher and cease to provide resilience?

I estimate that during the Global Financial Crisis of 2008-9, all three of the relief rallies during that time period had Micro MRIs that peaked at levels just a week away from last Friday’s reading (assuming the average weekly Micro MRI move over the last 100 years). Of course, this time it could be different, but I believe extra caution is justified considering the magnitude of the economic problems the pandemic is causing.

Indexes that Move Opposite to Stocks are At the Lower Ends of their Micro MRI Cycles

Three indexes – namely, the US 10y Treasury bond index, a series called VIX, and credit spreads -- all have Micro MRI that are in the down-legs of their cycles and are at the lower ends of their historical ranges. These indexes move opposite to stocks; their MRI tend to move down when stocks go up (and vice versa). The indexes have been in the down-legs of their cycles for the last 6 weeks, consistent with increases in the stock market that we have experienced. The Micro MRIs for these three indexes are now at very low levels. The US 10y Treasuries Micro MRI is at the 25th percentile. VIX, a popular measure of the stock market’s expectation of variability based on S&P 500 index option (Link: https://en.wikipedia.org/wiki/VIX), has a Micro MRI that is at the 4th percentile. The credit spread index I use has a Micro MRI at the 25th percentile.

These statistics mean that these three indexes are close to beginning the up-legs of their MRI cycles. When they do stocks are likely to move lower. This information supports the view that the Micro MRI for the DJIA is at the upper end of its cycle.

Relief Rallies have Narrow Peaks, Often Occurring on a Single Day

As with other relief rallies in market history, the current relief rally is based exclusively on the up-leg of the Micro MRI – none of the other MRI are in the up-legs of their cycles and, therefore, none are providing resilience. Relief rallies tend to peak on just one day, whereas rallies based on the longer-term Macro MRI tend to have multiple peaks at similar levels over the course of several weeks or months. This means that stock prices in a relief rally tend to move higher quickly, then peak on one day, and then decline. Since the current rally has performed in a manner consistent with this general pattern thus far, I believe it is prudent to reduce aggressiveness in anticipation of the peak in the Micro MRI and hence the relief rally.

As mentioned in prior notes, extraordinarily good news, such as an effective vaccine and a fast economic recovery, could limit the stock market declines after the Micro MRI peaks. Based on historical patterns, stock prices may be flat during periods that have both no resilience and very good news, but it would be very unusual for prices to continue moving higher during a period of no resilience. As you know, the Focused 15 Investing approach does not make bets based on the assessments of such news.

For these reasons, I took the unusual step of suggesting to reduce account aggressiveness. I suspect this guidance will be in place for several weeks.