This post contains:
· Performance Review of 2020 model portfolio performance compared to the DJIA
· An explanation for why the model portfolios are lagging the DJIA. This section includes charts showing concepts I have explained in text in weekly notes about the progressively higher troughs in the Micro MRI cycles over the last few years
· Current Valuation of the NASDAQ index that is an important part of the 2020 Recovery portfolio. This section explains why I believe it is too late in its short-term resilience cycle to switch to this portfolio
Note: I will discuss additional MRI shifts that signal greater longer-term resilience in an upcoming post.
Note: I will discuss additional MRI shifts that signal greater longer-term resilience in an upcoming post.
For this year, unfortunately, the performance for the model portfolios is flat or negative. The figures in the first column are for the period from Friday December 27, 2019 through Friday August 21, 2020. Those in the second are for the six-year period beginning at the inception of Focused 15 Investing - they are presented for a longer-term perspective.
RATES OF RETURN
December 27, 2019 July 18, 2014 -
August 21, 2020 August 21, 2020
Diamond uses DJIA-linked ETF “DDM”
Diamond (DJIA x2) – 3 ETFs (sg131) -9% 14%
Diamond-Onyx 35-65 Mix – 5 ETFs (sg218) 0% 13%
Sapphire and Emerald use DJIA-linked ETF “UDOW”
Sapphire-Onyx 50-50 Mix - 4 ETFs (sg299) -8% 21%
Emerald-Onyx 50-50 Mix - 5 ETFs (sg301) -8% 20%
Dow Jones Industrial Average (DJIA) -1% 11%
Thus, our portfolios have returned about 7 or 8 percentage points less than the DJIA for this year. However, most of this underperformance has occurred over the last nine weeks, since June 19, 2020. As of June 19th, the “Diamond (DJIA x2) – 3 ETFs (sg131)” had returned -10% while the DJIA returned -9%. Although our defensive posture from June 19 through August 21 caused us to miss out on some gains, I believe there have been sound reasons for this defensive posture. I’ll break this 9-week period into to two sub periods.
From June 19th through July 17th there were no sources of resilience. All of the MRI were in the downlegs of their cycles. Thus, the algorithms called for low exposure to the DJIA-linked ETFs. The DJIA climbed during this period, which can happen even when there is no resilience if there are other mitigating factors. In the current situation, I believe both the government stimulus and the Fed’s commitment to keep rates low for a long period of time have created support for stock prices in the face of an abrupt economic contraction.
On July 17th (six weeks ago), the Micro MRI somewhat unexpectedly formed a trough at a relatively high level and shifted to the upleg of its cycle. I’d like to show graphs that help explain my past comments on this inflection point in the Micro MRI and why we might miss some of the positive returns of the DJIA associated with this upleg of the Micro MRI. In the note a few days later (on July 22nd), I stated
Going forward, one possibility is that the Micro MRI moves higher for a few weeks, taking prices higher than the June highs. If this is the case, we will have to wait several weeks to assess the potential of a second bottom of the W-shaped market recovery pattern.
Over the last 100 years, there have been many instances of the Micro MRI forming a trough at a moderate level (at roughly the 50th percentile). In the research that led to the current algorithms, I found that when there is a trough at a moderate level, the subsequent trough may come more quickly and be particularly deep. This would imply that the DJIA stock prices would move higher for a short time over the next several weeks and then decline to a low level. This type of delayed and exaggerated decline did not always follow this pattern (i.e., trough at a moderate level), but it did often enough that it is best (from a portfolio-level risk-and-return point of view) for the algorithms not to move aggressively back into the market when the trough occurs at roughly the 50th percentile. Instead, it is best to wait for that subsequent deeper downleg to occur before moving back into the market.
Thus, all else equal, we will have low target weights for the DJIA-linked ETFs for the next few weeks. Of course, if the Exceptional Macro or the Macro MRI move to the positive legs of their cycles or other metrics indicate stronger resilience, the target weights will reflect those changes.
The following images illustrate these ideas. In the image immediately below, the DJIA price appears on the upper panel. The Micro Market Resilience Index (Micro MRI), which measures the bursts of resilience lasting 5 to 15 weeks, is on the lower. The Micro MRI moves around the horizontal blue line, which approximates the 50th percentile level. The pandemic-related troughs (March 20, 2020) in each panel are labelled.
(Contact use for the image: https://focused15investing.com/contact)
As of March 20, the Micro MRI formed a deep trough (at less than the 1st percentile of levels since 1918, meaning it was at the lowest extreme) and indicated a high likelihood of the DJIA moving higher as the Micro MRI moved to the upleg of its cycle. The DJIA did indeed move higher after that trough.
The next trough in the Micro MRI, which occurred on July 17, was noteworthy and surprising. It was noteworthy because it happened at a relatively high level – at about the 50th percentile. The troughs are more typically much lower at around the 15th percentile. As mentioned above, when there is a shallow trough, the following Micro MRI trough and price decline tend to be deeper. This pattern does not always take place, but it does take place often enough that it is best not to chase prices higher. This is programmed into the algorithms. Thus, the current underperformance of the model portfolios is consistent with the algorithm exercising caution in these circumstances.
The impact of not having exposure to the DJIA-linked ETFs is clearly evident in the performance of the model portfolios that focus primarily on the DJIA-linked ETFs. The chart below shows the returns of the Diamond (sg131) model portfolio compared to the DJIA since July 18, 2014 (the inception of Focused 15 Investing).
For model portfolios that combine the Onyx sleeve with Diamond, the adverse impact being out of the DJIA-linked ETFs this last several weeks has been muted. The Diamond-Onyx 35-65 Mix (sg218) is a mix of 35% Diamond and 65% Onyx (consisting of four low variability ETFs) and it has a slightly different pattern. It is represented by the blue line below, which, as one can see in the chart below, moves higher (instead of being flat) over the last several weeks because of the Onyx sleeve’s exposure to ETFs tracking consumer staples and utility stocks.
Progressively Higher Troughs in the Micro MRI Beginning in 2018
I mentioned that the most recent trough was surprising. It is surprising because it seems to continue a pattern of progressively higher troughs that began in early 2018. The chart below shows the progressively higher troughs in Micro MRI beginning in early 2018. (Obviously, the COVID-related trough in March of 2020 is an exception to this trend.)
This 2 ½ year pattern suggests a progressively shorter period of vulnerability and pessimism during the downleg of the Micro cycles, with the March 2020 decline being an exception.
After the decline in March, I thought that pattern of progressively higher troughs had ended. But now, it seems that prices might reflect a growing and unsustainable level of optimism.
Recall that the Micro MRI measures the short-term bursts of market resilience and optimism and the inevitable bursts of vulnerability and pessimism that follow. I believe these cycles are inevitable because the fair value of the index can never be determined with certainty. “Fair value” is a function of many variables, including future economic growth, inflation, interest rates and, currently, the pandemic. Investors as a whole as represented by the market indexes make guesses about fair value, and their guesses tend to overshoot and undershoot fair value on a regular basis as they try to determine it. The cycles are created when prices move ever higher, to the point where increases are far above the fair value of the index. When continued price increases become unsustainable, prices move lower. Prices then decline as investors as a whole try to determine a fair value perceived to be lower than the current price. They typically overshoot fair value as vulnerability and pessimism set in.
When the period of pessimism is truncated at a high level (i.e., when the troughs occur at high levels, as they have been doing), it is an indication that the market is either (a) identifying a higher level for the fair value, or (b) the market is becoming overly optimistic (or delusional) about the future growth of the economy and/or other factors that are used to determine fair value. There are examples of both (a) and (b) over the last 100 years.
The algorithms are designed to be conservative in this situation; that is, they do not chase prices higher after a shallow inflection point. Subsequent price declines may be deep and abrupt. This conservatism has been the better course of action over the last 100 years. However, this conservative stance has not been rewarded thus far in 2020.
The case for this being a period of excessive optimism is supported by the following valuation information for NASDAQ and the high recent returns of a small group of stocks discussed below.
Current Valuation of the NASDAQ 100 Index: Too Late to Get Into for this Cycle
The NASDAQ 100 index has had strong performance since the end of 2019. From 12/27/2019 to 8/21/20202 (last Friday), it returned 32%, which is much higher than the -1% return for the DJIA mentioned at the beginning of this note.
The NASDAQ 100 ETF “QLD,” which gives two times the return each day, is a key part of the 2020 Recovery portfolio: Diamond-Onyx 35-65 Mix ‘2020’ - 5 ETFs (sg218.2). This model portfolio has returned 13% over that same period. As much as I would like to have everyone get the high returns of the NASDAQ in the recent market, I believe it is too late in the Micro MRI cycle to move into this model portfolio right now.
The Micro MRI for the NASDAQ 100 index is at the 74th percentile, indicating that it is currently in the upper portion of its normal range. While the algorithms are intended to reduce the target weight of this index when its MRI approaches a peak, the algorithms may not avoid all losses when the Micro MRI finally does peak. The NASDAQ has a history of large decline occurring abruptly. The current target weights for “Diamond-Onyx 35-65 Mix ‘2020’ - 5 ETFs (sg218.2)” indicate a relatively small allocation of 6% to QLD compared to a maximum allocation of 15% for that model portfolio. Of course, any subscriber can decide on their own to use the Recovery portfolio, but I can give guidance for everyone to make this switch.
A look at current valuation measures reinforces that the NASDAQ is at high price levels. A common valuation measure is called the Price-to-Earnings ratio (PE ratio). This indicates the price compared to recent annual earnings. As of last Friday, the PE ratio was 37 for the NASDAQ 100, meaning that the price is 37 times recent annual earnings. The index ended 2019 with a ratio of 27, and the ratio dropped to 21 in March of this year. Unfortunately, one cannot determine the PE ratio that represents a fair value because it depends on future growth, interest rates, inflation and other factors. So, we look at the past for reference.
As a comparison, NASDAQ’s PE ratio was 33 at the peak of the index (10/26/2007), just before the Global Financial Crisis. After that date, the NASDAQ 100 price level dropped by about 52%. I am not suggesting a drop of the same magnitude, but I am saying we may be closer to the top of the short-term cycle than the bottom. Differing interest rate environments across time weaken some of these comparisons. For example, the yield on the 10-year Treasury bond was about 4.5% at the end of 2007. Today it is at about 0.7%, and so today’s low interest rate environment may justify higher PE ratios, all else equal. This is where the MRI are useful in comparing cycles across time. The Micro MRI is currently at the 74th percentile of levels since 1972 (the beginning of the NASDAQ Composite). If we assume that the short-term peak of prices and the Micro MRI is at about the 85th percentile, we might have a few weeks of prices moving higher before prices move lower due to a lack of short-term resilience.
Thus, I believe there will be a better time to use the NASDAQ later on. Further, I am evaluating how NASDAQ can be included in the regular model portfolios. More on this later.
As further evidence suggesting the wisdom of not chasing the NASDAQ, consider the following article from Bloomberg news. The stocks mentioned below are heavily weighted in the NASDAQ index. You have heard of different letters to describe marked patterns (e.g. V, W, L). The article referenced below describes a K-shaped market recovery (what makes it look like a K is described below). It says that the current wide gap between the return of internet/tech companies that are heavily weighted in NASDAQ such as Facebook, Apple, Amazon, Netflix, and Google (called the FANG or sometimes FAANG index) and the broader market is a sign of an impending market crash. The case for big price gains for the FAANG group of companies is that pandemic-related lockdowns drive business to these internet and high tech businesses.
The blue line rising steeply since the March 2020 lows is the FANG index. The black line represents the Russell Top 50 (an index of the largest 50 companies in the US). The growing gap represents the arm and leg of the K. (The Russell 2000 of small company stocks, is also shown). The article states:
… it is generally a sign that a trend is reaching a peak…
The message of this article is that the gap between FAANG (and NASDAQ) and other indexes will close. Some researchers say that the price of FAANG stocks will drop dramatically when there is progress on treatments and vaccines for COVID. Further, the article predicts that the drop in FAANG will also cause a drop in the broader indexes.
I believe the current price of NASDAQ is far in excess of fair value. I also see the MRI conditions for the DJIA improving. The NASDAQ may move down and the DJIA may move up as the jaws of the K close. The algorithms are likely going to wait for a stronger signal to move back in the DJIA-linked ETFs. Until then, the model portfolios will be defensive.