Weekly Note - November 18, 2020

Last week I discussed options (see Note 1 below for a link) based on whether the market declined last week and the length of your investment horizon. The market did not decline and I list the relevant options and have added notes in italics: 

1. You have a long investment horizon: Continue using your current model portfolio. An investment horizon of roughly 7 years or more can be considered a long investment horizon. You can disregard the guidance to hold Box #2 Cash – simply keep it at your regular amount (e.g. 3%).
2. You have an investment horizon shorter than 7 years, and…

• A) You are currently using one of the Onyx mixes: Continue using your current model portfolio. Follow guidance regarding Box #2 Cash.
• B) You are NOT currently using an Onyx Mix. Consider switching to an Onyx mix model portfolio, which tend to be less aggressive and are likely to be more tolerant of a quickly weakening economic situation. Follow guidance regarding Box #2 Cash. 

As of this writing, it appears that we will make it through the current period of vulnerability this week and next without declines of more than roughly 15%.  Over the coming week(s), I will review the strength of the growing resilience and may further decrease Box #2 Cash, and, if it makes sense, for those with a short horizon (e.g. less than 7 years) to move into more aggressive model portfolios. We may be entering a period of high resilience lasting several quarters, and many subscribers may want to move to more aggressive portfolios to take advantage of this. 

Please contact me with any questions about these options.

This post covers:

• Current Outlook Implied by Current MRI Conditions
• NASDAQ versus DJIA
• Valuation and Political Concerns 

Outlook Implied by Current MRI Conditions

These views do not affect the target weights of the model portfolio, but they are consistent with a broad range of MRI conditions and economic variables I review each week. When the MRI conditions change, the outlook will change.  

With multiple promising vaccines, investors can begin to focus on economic recovery in greater detail. Prior to the success of a few vaccine trials, the timing of the end of the pandemic and its related economic effects was uncertain. Now, there is increasing clarity. As you may recall from prior notes, in normal times, stock market investors try to anticipate the economic conditions that will exist 6 to 9 months in the future. Near term expected conditions have less importance. This means that the expected near-term difficulty of the pandemic and any lockdowns will have less of an impact on their decisions.

In addition to now having multiple promising vaccines, other factors contribute to optimism for economic growth in 2021. These include government economic stimulus efforts around the world, the US Fed’s promise of low interest rates for the foreseeable future, and pent-up consumer demand from months of reduced spending. 

 
Last week I mentioned that high current stock valuations are a concern. High current valuations could limit additional price gains. However, I believe the price of the DJIA will be supported over the next several weeks by the following factors:

• Rotation of the market to industrial company stocks from technology company stocks. Technology stocks that have done well during the pandemic will underperform those that have lagged as the economy reopens. The tech-heavy NASDAQ has done far better these last months than the S&P 500 or the DJIA. The last 52 weeks of price movements is shown in Figure One below, which is discussed later. I believe the DJIA is likely to close the performance gap with the NASDAQ index over the next few months, with the DJIA moving higher.
• The growing resilience of the DJIA. Several of the MRI for the DJIA are at inflection points and moving to the uplegs of their cycles. In addition, they are doing so at low levels in their cycles, which suggests that these uplegs may last many weeks. The Macro MRI measuring the longest cycle of resilience lasting several quarters or years is at the 29th percentile of levels since 1919 – a relatively low level. And the Exceptional Macro is now present, which is a very positive sign. The Micro MRI, measuring the shortest cycles of resilience, is beginning a transition to the upleg of its cycle at the 20th percentile since 1918. These transitions are taking place now, and, although there can be higher volatility around these inflection points, the upside for prices is greater than the downside based on these readings.
• Weakening US dollar. In my review of the MRI conditions of 80+ indexes from around the world, the potential for a weakening dollar appears to be most imminent factor producing US stock price gains. Over the next several weeks, the US dollar will be more vulnerable to declines compared to other major currencies. As opposed to companies in the S&P 500, those in the DJIA get more of their earnings from outside the US. When the dollar weakens, the value of those earnings increases in dollar terms, which supports higher prices. This factor is in addition to the benefits of a potential end of the pandemic and the expected strengthening of the economic recovery.

I expect there to be ups and downs around the time the US Congress debates and votes on the next stimulus bill. Barring a complete failure to pass a bill, I expect the market to move higher through this period.

NASDAQ versus the DJIA

The tech-heavy NASDAQ index has returned about 45% over the last 52 weeks. The S&P500 has about 17%. The DJIA has returned just under 8% over the same time period. The pattern, especially between the NASDAQ and the DJIA fit a “K-shaped” market recovery, which I described briefly in (link: https://marketresilience.blogspot.com/2020/08/performance-review-nasdaq-valuation.html).

The forward strokes of the letter “K” can be likened to the performance of the NASDAQ (upper) and the performance of the DJIA (or S&P) (lower). The last 52 weeks of price movements is shown in Figure One below.

Figure One – NASDAQ, S&P500, DJIA – Return over last 52 weeks

The MRI statistics of the NASDAQ and DJIA index suggest that the DJIA may move higher to close the performance gap. I have already described the growing resilience of the DJIA. It is primed to move higher. The NASDAQ has quite different readings:

                                                    DJIA           Leg of cycle       NASDAQ      Leg of cycle

  Macro MRI percentile level      29^th               upleg                    65^th           downleg

  Exceptional Macro                    Yes (new)                                  Not present

  Micro MRI percentile level       20^th              upleg                    26^th            downleg

Based on these MRI and other considerations, over the next several weeks, I believe that the most likely movement is for the NASDAQ to decline and the DJIA to move higher. 

Valuation and Political Concerns

I do have concerns about the valuation of the stock market, which I mentioned last week (see Note 1, below). I wonder if investors in general believed over the past 9 months that as long as there was no vaccine, it was more likely that government stimulus would continue to expand. Now, with at least two promising vaccines, investors may be less interested in the work-from-home investment theme that has favored the NASDAQ index, and may therefore start paying more attention to valuation and growth. If this concern is justified, in early 2021 we may see more volatility in the markets as actual company earnings growth is compared with the expectation of high growth post-pandemic. However, based on historical precedents, as long as interest rates stay low the time that investors in general focus on valuation is likely a few months away. 

We also have upcoming political issues and transitions.  Passage of an additional stimulus bill is important to the stronger economic growth expected in 2021.  Should this be derailed or there are unexpected difficulties in the transition to the new US administration, growth may be slowed and be a downward force of stock prices.       

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Note

   1) https://marketresilience.blogspot.com/2020/11/weekly-note-november-11-2020.html

Weekly Note - November 11, 2020

The post describes

1. Options for Near Term (rev 11/12/2020)
2. Current MRI conditions
3. Recent performance of the popular model portfolios
4. Current stock valuations

Options for Near Term

Over the last few weeks, I have described a few options for switching to a different model portfolio. I’d like to expand that description to form a few different scenarios for you to think about before the next Plant season. Thus, the options are as follows (rev highlighted):

1. Continue using your current model portfolio regardless of DJIA prices moving higher or lower over the next week or so. This may be most suitable for people with longer investment horizons.
2. If there ARE dramatic price declines (e.g., declines greater than 15%) over the next week or so, one can, soon thereafter, switch to a more aggressive model portfolio to take advantage of the rebound. I suspect a few subscribers will seek to do this.
3. If there are NOT major price declines over the next week or so, one can switch to an Onyx Mix if not using one at this time. These portfolios are less aggressive and are likely to be more tolerant of a quickly weakening economic situation.

Current MRI Conditions

The Macro MRI—the MRI tracking a longer-term cycle of market resilience—has been in the downleg of its cycle since early 2018. It is now at the 29th percentile of all levels since 1918. Over the last 100+ years, there have been about 10 times that the Macro MRI troughed (i.e., turned positive) at this level or higher. There have been roughly 14 times that the Macro MRI has troughed at a lower level. From this perspective, I do expect a trough in the Macro MRI over the next few weeks.

Regarding the Micro MRI, it continues to trend lower and was at the 20th percentile of levels since 1918. It trended lower last week even though DJIA prices moved higher. The current level, like that of the Macro MRI, is at the lower end of its normal range, which suggests that a shift to the upleg of the cycle may occur in the next few weeks. Thus, the portfolios are likely to have increased exposure to the DJIA over the coming weeks.

Performance Review  

The tables below present performance figures for the most popular Focused 15 Investing model portfolios. Most of the other portfolios shown on the publications are more aggressive or more conservative versions of these.

      2020 Has Been a Challenging Year

This has been a challenging year for the model portfolios in terms of performance.

Of the five most popular model portfolios, only one (sg218) has performed better than the DJIA. The others had returns ranging from a loss of 10% to a 0% return.



The main cause of the low returns is that our portfolios became very conservative (high target weights in cash) in June and have missed the positive returns since then. The target weights followed the MRI cycles as intended, but market returns were heavily influenced by, I believe, low interest rates and massive economic stimulus from governments around the world. Their measures more than compensated for the lack of resilience in the market. The Focused 15 Investing approach explicitly avoids making bets on news-of-the-day events, which, in most environments, enhances returns. But in 2020 this has not been the case. I believe 2020 will be an unusual year and that no change in the approach should be made.

      The Onyx Sleeve Has Performed Well

The model portfolios that include the Onyx sleeve along with the DJIA-focused sleeve have performed better than those that focus just on the DJIA-linked ETFs. The first two listed are the DJIA-focused portfolios. The remaining three mix a DJIA-focused sleeve and the Onyx sleeve.

I designed the Onyx sleeve in 2013 to provide reliable returns in lower interest rate environments. Its goal is to provide consistent returns when bond returns are low. As you may recall, Onyx consists of four low volatility ETFs:

• XLP – Consumer Staples Stocks
• XLU – Utility Stocks
• UST – US 7-10 Year Treasury bond index x2
• SHY – 1-3 Year Treasury bond index

The MRI-based signals rotate target weights among these four ETFs favoring the more resilience and avoiding the more vulnerable. The recent 2-year period has been a useful test for the Onyx sleeve. While the DJIA-focused sleeve has history beginning in 1918, the Onyx sleeve’s history begins in 1991, which is quite a bit shorter. Over the last 2 years, we have had a major crisis (the pandemic) and periods of concerns about rising and declining interest rates. The Onyx sleeve has performed well during these periods, and I am confident that it can provide positive returns in a wide variety of market environments. It is important to note that Onyx has lower long-term returns than the DJIA-focused sleeves but is a good complement to the DJIA-focused sleeves. Thus, I provide Onyx mixes in all weekly publications.

While it looks like the Onyx mixes are superior to the DJIA-focused portfolios, the DJIA-focused portfolios perform better just after the Macro MRI turns positive. To illustrate this, I will show additional information for only the main DJIA-focused portfolio, Diamond (sg131), and the main Onyx mix, which is the Diamond-Onyx Mix (sg218). 

The best example strong performance after a trough in the Macro MRI over the last 20 years is 2009, just after the DJIA declined by about 50% because of the Global Financial Crisis. As shown in column B below, both the DJIA-focused and Onyx mix portfolios do better than the DJIA. But the DJIA-focused Diamond (sg131) performs better, returning 39% compared to the 27% of the Diamond-Onyx Mix (sg218).   

While the Diamond-Onyx Mix (sg218) has had better performance in 2020, Diamond (sg131) has better performance over a much longer period. The table below includes the 20-year performance figures for a set of popular model portfolios. The figure in columns C, D, and E are annualized.   

One can see that even though Diamond (sg131) has had poor performance in 2020 (year-to-date), it still has better long-term returns than Diamond-Onyx Mix (sg218).

Current Stock Valuations 

Stock valuations are high compared to the historical range of the last 20 years. Common valuation measures are listed below — the higher the valuation, the more expensive the stocks. In general, one wants to buy stocks when valuations are low and sell them when valuations are high.

• Price-to-earnings ratio: This ratio relates the current index price to the earnings of all the companies in the index. In the second quarter of 2020, company earnings declined dramatically because of the pandemic, and this temporary shift can inflate the price-to-earnings ratio.
• Price-to-book ratio: This ratio relates the current index price to the assets of all companies. Assets include things like factories and equipment, which are not as variable as earnings. Thus, this ratio tends to be more stable by being less sensitive to earnings fluctuations from year to year.

The following data is from Bloomberg. It shows these valuation measures for the DJIA are at high levels compared to those of the last 20+ years. The top panel shows the price history for the DJIA (total return on a log scale), and the time period covered is 1997 through early November 2020.

Over the last 20 years, there were two major declines prior to 2020:

• 2002 – Decline of roughly 30% during the post-9/11 recession
• 2008 – Decline of roughly 50% because of the Global Financial Crisis

The subsequent panels show the valuation ratios for price-to-earnings, and price-to-book. The horizontal red lines show the current levels of those ratios. Prior to the decline of 2002, the price-to-earnings ratio was at a high level – a level similar to today’s. 

Prior to the decline of 2007/8, the price-to-book ratio was at a high level – a level similar to today’s. The high valuation levels suggest that stocks are expensive and may not move much higher.

However, at far left of the chart the valuation, note that levels are higher than the current levels indicated by the red lines. This was the end of the Internet Boom of the late 1990s. Even though the Internet Boom primarily affected the NASDAQ index, the valuation measures of the DJIA also showed high valuation statistics as well. This early period may be a useful comparison for the current period. The shutdown measures to contain the virus have boosted the prices and valuations of Amazon, Apple, Netflix, etc., and the DJIA stocks may be affected as well.

As mentioned in prior notes, there are factors that may make long-term historical valuation analyses less relevant in the current situation. One factor is the Fed’s pledge to keep interest rates very low for a long period of time and to buy assets on the open markets to reduce fears about market declines. Also, governments around the world have spent billions to compensate for reduced employment and business activity. The personal savings rate in the US has moved sharply higher in the pandemic (link: https://www.statista.com/statistics/246268/personal-savings-rate-in-the-united-states-by-month/). As soon as the risk of Covid-19 reduces because of an effective treatment and/or vaccine, spending may be unusually high as people make purchases that have been delayed during the pandemic.

Thus, the current valuation of the DJIA stocks may not be excessive considering future growth related to the massive government stimulus and low interest rates.

Nonetheless, the issue of high valuations remains a concern because a sharp rebound of economic activity could reduce the will of the Fed and Congress to provide support. They may be less willing to extend their extraordinary support for the economy, which would remove key supports for maintaining stock prices at high valuation levels.

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