Weekly Note - December 30, 2020

Market Resilience Index series - DJIA  

The DJIA continues to be resilient. The main Market Resilience Indexes, their directions, and levels (in terms of percentile within all weekly levels since 1918, except for the Exceptional Macro) are listed below:

• Macro: Positive leg of cycle and moving higher; providing resilience. Currently at a low level in its cycle (34th percentile, up from 32nd last week)
• Exceptional Macro: Present and providing strong resilience
• Micro: Negative leg of cycle and moving lower; no longer providing resilience. Currently at a high level in its cycle (72nd percentile, down from 78th last week)

Market Comment 

As of last Friday (12/25/2020), two of the three main MRI listed above (i.e., Macro and Exceptional Macro) were providing resilience for the DJIA. If historical precedents hold true, the market will recover reasonably quickly and completely from news-related losses that may occur. There is a good chance (slightly greater than 50%) of the DJIA moving higher, despite a Micro MRI being the downleg of its cycle. This is because the Exceptional Macro is present and its strength can compensate for the lack of resilience from the Micro MRI. We have seen evidence of this phenomenon last week and so far this week – the DJIA is not declining even though the Micro MRI is the in the downleg of its cycle.  

However, the next roughly six weeks are likely to be more volatile for the DJIA (i.e., rapid price moves up and down) than it has been over the last roughly six weeks. While there is less than a 50% chance of overall declines over this period, there is still enough of a chance that we should not ignore the possibility that the DJIA will be at a lower level in six weeks. Thus, the suggested additional cash for Box #2 Cash for those with shorter investment horizons, as indicated above in section C of the weekly email, until we get further through the downleg of the Micro MRI.

Regarding the MRI conditions of global markets, many of the major stock markets are in a similar situation as the DJIA – a Macro MRI that has just moved to the upleg of its cycle, the strong presence of the Exceptional Macro MRI, and a Micro MRI that has just moved or will soon move to the downleg from a very high level. This applies to these markets: S&P 500, MSCI World Stocks (MXWO), US Industrial Stocks (S&P and DJ), US Transports, Energy Stocks (SPGS), US Small Company Stocks (Russell 2000), UK Stocks, Europe Stocks, Emerging Market Stocks, Shanghai Stocks (in USD).

This statement also applies to Bitcoin, and several commodities (excluding precious metals). Contributing to these conditions is that the US dollar continues to lack any source of resilience. The US dollar is very vulnerable to continued declines. 

The obvious omission from this group is the NASDAQ stock index. It’s Macro MRI is currently in the downleg of its cycle and is not providing resilience.

It looks like 2021 is starting with a wide range of very resilient markets, which would present a welcome change from 2020. The short-term vulnerability of the Micro MRI for these markets over the first several weeks of the year may induce some additional concerns. Should those concerns pass without negatively influencing investors globally, we will likely see global markets move quickly higher.

end

Weekly Note - December 22, 2020

This post discusses the following points:

1. Current MRI Conditions for the DJIA
2. Near-term Outlook for Other Indexes
3. Current Research for a Possible Replacement for the 2020 Recovery Add-in Sleeve

1. Current MRI Conditions for the DJIA

This section is an update of my comments last week about the current MRI conditions for the DJIA.

The DJIA continues to be resilient. The main Market Resilience Indexes, their directions, and levels (in terms of percentile within all weekly levels since 1918, except as noted for the Exceptional Macro) are listed below:

• Macro: Positive leg of cycle and moving higher; providing resilience.  Currently at low level in its cycle (32nd percentile, up from 31st last week)
• Exceptional Macro: Present and providing exceptional resilience 
• Micro: Currently registering as positive, but beginning to shift to the downleg of its cycle. Currently at a high in its cycle (78th percentile, down from 79th last week)

As of last Friday (12/18/2020), all three main MRI were providing resilience. If historical precedents hold true, the market will recover reasonably quickly and completely from news-related losses that do occur.

Generally speaking, the Exceptional Macro is either present or not, therefore there is no level associated with it. Historically, a present Exceptional Macro a) suggests that a more positive Macro MRI will develop in the subsequent few weeks, b) occurs infrequently, and c) can fully compensate for the low resilience of a downleg in the Micro MRI cycle.

Given the importance of the Exceptional Macro at this time, I am watching it closely. If it deteriorates meaningfully and ceases to provide exceptional resilience, I will not hesitate to increase the suggested Box #2 Cash level outside of our regular trading schedule. But for now, the Exceptional Macro is present for many markets (not only the DJIA), and a more positive Macro MRI is developing as expected for these markets – an indication that many stock markets are developing stronger long-term resilience.

We can expect the Micro MRI to be in the downleg of its cycle over the next few weeks. There may be some short but painful declines associated with this status during this period, but recoveries are likely to relatively quick and complete. If historical precedents hold true, the other MRI will provide enough resilience to compensate for the lack of Micro (short-term) resilience.  But because historical precedent may not fully apply to 2020, I am maintaining my suggestion of Box #2 Cash to remain at 20%.  

2. Near-term Outlook for Other Indexes

Despite coming to the end of 2020 and hoping for a better 2021, the economic repercussions of the pandemic will be with us for a while. The shock of the economic shutdown and the steps taken by governments globally to stimulate the world economy have had extraordinary impacts on the market. These shocks will reverberate through the markets for some time. Below are some of the MRI conditions that stand out among the many indexes and markets that I monitor each week.

• Continued resilience of stock prices – Resilience continues to build in the DJIA and other US stock market indexes, even though many are close to all-time highs. Increasing resilience is evident even for the NASDAQ, which recently had some deterioration in its long-term (Macro) resilience.
• Investors shifting to favor value stocks compared to growth stocks – Growth stocks, such as Apple, Amazon, and Google, have had stronger returns than value stocks (such as JP Morgan, Johnson & Johnson, Walt Disney, and Verizon) over the last several months. I evaluate the relationship between growth stock indexes and value stock indexes. We are currently at an inflection point in the Macro MRI of this comparison. This suggests that value stocks will have stronger returns than growth stocks over the coming months. This shift should provide support for the DJIA-linked ETFs (DIA, DDM, UDOW) because they are biased toward value stocks. This shift has been taking place for several weeks and has been expected by many investors. But over the coming months, the outperformance of value stocks is likely to be more dramatic. If this shift does indeed become more dramatic, it would indicate an end to the useful life of the current 2020 Recovery sleeves (sg20.1 and sg20.2), which have a growth bias because of their use of the NASDAQ-linked ETFs.
• Continued weakness in the US dollar – I mentioned in my November 18th note that this is an important factor in supporting stock prices. It appears that USD dollar weakness will continue for a few more weeks. A weaker dollar boosts the value of the foreign earnings of US companies and make US-produced goods and services more attractive globally. Many of the DJIA companies have global businesses and benefit from a weak dollar. Even smaller companies outside the DJIA benefit because their goods become cheaper to customers in other countries.
• Continued resilience of commodity prices – Many commodities are priced in dollars, and a weakening US dollar boosts the prices of commodities, all else equal. Commodity prices can also increase because of higher expected future economic growth. At the moment, we have both a weaker US dollar and an expectation of higher economic growth in 2021. This shift is currently most easily seen in the SPGS Commodity index, for which the Macro MRI has become positive, suggesting higher commodity prices longer term.
• Inflation concern remains low – I evaluate the relationship between the Global Inflation-Linked Bond index and the World Government Bond Index to monitor inflation concerns. The MRI dynamics of this relationship suggest inflation concerns will remain low for the next several weeks.
• Reduced resilience (greater vulnerability) of the 10-year Treasury Bond index – I expect many model portfolios to shift out of the 10-year index-linked ETFs (IEF, UST, and TYD) over the next several weeks because of the weaker resilience of 10-year bond prices. A decline in bond prices can start to undermine the attractiveness of stocks because reduced bond prices create higher bond yields.  At a certain level of increased bond yields, stock investors may view the bonds more favorability by comparison. 

3. Current Research for a Possible Replacement for the 2020 Recovery Add-in Sleeve

The ongoing economic and market conditions related to the pandemic are likely to influence many stock, bond, and other markets through 2021. My examination of these conditions may lead to a new Recovery sleeve (perhaps called “2021 Recovery”) that would replace the current 2020 Recovery sleeve. Following are a couple of topics that I see as particularly relevant; all of these have signal sets done in the 2007-2010 period. 

1. Possible continued strength of the NASDAQ index – I am examining the possibility that the unprecedented level of government stimulus around the world this year will lead to much higher prices for stocks than we currently observe. Some market strategists believe that government efforts in the late 1990s to recover from the Asian and Russian debt crises and a crisis related to the hedge fund Long Term Capital Management meaningfully contributed to the subsequent internet boom from the mid-1990s through 1999 and following bust. During the internet boom, the NASDAQ index far outperformed the DJIA and S&P 500. While the NASDAQ has already outperformed these indexes over the last year, the economic stimulus this year is far greater than it was in the late 1990s. It is conceivable that NASDAQ could continue to push higher.  If this occurs, the current structure of the 2020 Recovery sleeve (sg20.2) may be sufficient. 
2. The following markets are experiencing troughs in their Macro MRI. These indexes may move higher over the next year and beyond. My current research relates to whether their expected returns will be superior to what we are likely to obtain from our main portfolios.

a. Commodities – As mentioned above.

b. Emerging market stocks and bonds – Many of these investments are based in Asia which has been spared many of the economic setbacks the US and Europe have experienced in 2020. Emerging markets also benefit from the stimulus by governments around the world. They may experience high exceptionally high returns in 2021.

c. US small company stocks – While I do expect there to be many more corporate bankruptcies in 2021, stock index ETFs have a survivor bias. Companies that go out of business are dropped from the index – only survivors remain. The stocks of surviving companies may increase in price quickly as the economy recovers.

These and other market developments may justify an updated recovery sleeve. From the subscriber’s perspective, if one elects to use an updated recovery sleeve, that sleeve would simply have different ETFs in it.

At this time, I do not anticipate changes to the main model portfolios. The DJIA-linked ETFs are likely to be stronger in 2021 than they were in 2020.

Weekly Note - December 9, 2020

Current MRI Conditions and Near-Term Outlook

Resilience is increasing in stock markets around the world. The growing resilience represents a broad shift in the long-term trend of the market.  This shift does not mean that stock market prices will only go up.  Instead, it means that recoveries from declines that do occur will rebound quickly to prior price levels. 

The market resilience index that indicates the long-term cycle of resilience – the Macro MRI - is shifting to the upleg of its cycle for many stock markets around the world.  The Macro MRI for the DJIA, for example, is shifting to the upleg of its cycle and doing so at a low level – the 30^th percentile of levels since 1918.  All else equal, the Macro MRI moving higher from a low level is supportive of stock prices moving higher for several quarters. 

The Exceptional Macro MRI, which appears only infrequently and foreshadows a stronger positive Macro trend is present for many stock indexes as well.  For the twelve major stock indexes I monitor closely (e.g., DJIA, NASDAQ, US large company, US small company, emerging market, China, UK, Europe, Japan) all but two have positive Macro MRI and/or Exceptional Macro MRI present at this time.  The exceptions are Japan stocks and NASDAQ, which lack both. 

However, the Micro MRI (indicating the shortest cycle of resilience) for many indexes have been positive for a few weeks and have moved quickly to the upper ends of their normal cycles.  For the DJIA, last Friday the Micro MRI was moving higher but was at the 73^rd percentile of levels since 1918. Given this high level, it is likely to move to the downleg of its cycle over the next few weeks, which would in other conditions produce price declines that we would try to avoid.  But a key point for all the stock indexes in this condition is that the resilience from the Exceptional Macro and Macro MRI typically provide ample resilience to compensate for any lack of short-term (Micro) resilience. 

Based on the MRI conditions for DJIA, the algorithms conclude that stock prices may not change much or may move higher over the next few weeks.  Declines that do occur will be recovered quickly (unless there is extremely negative news). 

These conditions are most consistent with strong market performance lasting for several quarters.  I subjectively place a 60% probability of this happening. 

 

High Valuations Are Likely to Get Higher

High current stock valuations could be a headwind to further price increases.  While the MRI-based investment approach does not directly consider valuation, it does measure what investors in general are perceiving as attractive investments considering a wide range of variables, including interest rates, future earnings and current valuations.  At the moment, the MRI suggest that investors in general are not highly concerned about valuation levels.  As stock prices increase, valuation measures will likely edge higher. 

See this blog post for comments about current stock valuations (it is a revised section from the “Weekly Note - November 11, 2020” blog post): https://marketresilience.blogspot.com/2020/12/research-note-stock-market-valuations.html

The 40% Chance of Vulnerability and Deep Declines in Early 2021

It is possible that this period of resilience could be cut short, for valuation or other reasons.  If it is cut short, overall market resilience could weaken as early as mid-January. I mention this timeframe because of the downleg of the Micro cycle occurring over that time – deterioration of the long-term trend is more likely to occur during this time.  At the moment, I would place a 40% chance of deep declines occurring, and this level is still high enough to be concerned with. 

If deterioration does occur over the next several weeks, I believe it will be accurately indicated by the end of the Exceptional Macro MRI.  If this does occur, I will not hesitate to suggest raising Box #2 Cash levels outside of the regular Friday trading discipline. 

Research Note - Why NASDAQ is Not in Main Portfolios

Background – NASDAQ and the 2020 Recovery Portfolio/Sleeve

The Focused 15 Investing publications have included a 2020 Recovery Portfolio or Sleeve since April 4, 2020.  A key contributor to its return has been NASDAQ-linked ETFs.  The NASDAQ stock index has a high concentration of technology companies. The top 10 holdings of the largest NASDAQ ETF are the following.

 

Name	% Assets
Apple Inc	13.00%
Microsoft Corp	10.70%
Amazon.com Inc	10.62%
Facebook Inc A	4.42%
Alphabet Inc A	3.89%
Alphabet Inc C	3.78%
Tesla Inc	3.22%
NVIDIA Corp	2.75%
PayPal Holdings Inc	1.94%
Adobe Inc	1.91%

   Source: https://finance.yahoo.com/quote/QQQ/holdings/

The top three holdings – Apple, Microsoft, and Amazon – make up over 30% of the total ETF.  Many of companies represented in these top holdings have done well during the pandemic. 

The 2020 Recovery Portfolio/Sleeve has been a good addition to the publication in terms of performance, but for many subscribers there has not been an easy way to incorporate it into their accounts.  The recent change (Oct 30, 2020) in the Shares-to-Trade worksheet makes it easier to incorporate this sleeve. 

As shown on the weekly publications, the 2020 Recovery Portfolios have performed well since their introduction and over the last few years (in simulations).  This raises the question as to whether the NASDAQ ETFs should be permanently included in the main model portfolios. 

The bottom line is that NASDAQ has performed well in 2020, but it is too soon to conclude that NASDAQ should be permanently added to the main model portfolios. Companies prominent in NASDAQ currently have high stock valuations, and, while NASDAQ has outperformed the DJIA (which pays a central role in our main model portfolios), this outperformance may not last in a manner that we can capture it. 

The rest of this post covers:

• An MRI-Based Analysis of NASDAQ: the performance of NASDAQ and the success of MRI-based decision rules
• Comparison of DJIA and NASDAQ Sleeves

 

An MRI-Based Analysis of NASDAQ

At the time I designed the approach we use in Focused 15 Investing (2007-2010), the NASDAQ was clearly an important index.  Yet its price history was short (beginning in 1972) and was dominated by the internet/tech boom of the late 1990s and the following bust.  I had no trouble at that time developing algorithms that effectively participated in the upside and avoided the downside of this boom and bust.  But I had little confidence that those algorithms would be effective in future cycles because the success was proven over just one cycle. 

Instead, I developed algorithms for the NASDAQ that were informed not only by this relatively short time span but also reflected the principles that had proven useful with DJIA and other major indexes. With those algorithms in place, I have been monitoring performance of NASDAQ-linked sleeves since then. 

The graph below shows the available price history of NASDAQ.  The prominent peak is in 2000.  This chart is on a log scale to show the variability over the entire historical period.  The decline from the peak in 2000 to the low point in October of 2002 is roughly 80% — a very painful decline. 

The chart also shows a vertical blue line at the end of 2007, which is when the NASDAQ algorithms were finalized. 

The graph below shows the performance of the NASDAQ algorithms that were finalized as of the end of 2007. One can see that, overall, the NASDAQ algorithms (yellow line) performed well relative to NASDAQ buy-and-hold (red). Yet, because these algorithms incorporate principles from other indexes, they do not participate in all the upside of the NASDAQ nor avoid all the declines after the peak in 2000.

 

 

There are four important periods in this history. 

1. From 1990 to 2000, the performance of the traded sleeve shown by the yellow line (rotating out of NASDAQ using MRI-based algorithms) underperformed the NASDAQ buy-and-hold (red). This pattern is expected in the MRI-based approach – after long positive price trends, the market tends not to decline during periods of vulnerability as investors become more euphoric.
2. During the decline of the NASDAQ from 2000 to October 2002, NASDAQ declined in price and in the unsustainably high valuations of the late 1990s. The traded sleeve avoided some of the losses of the NASDAQ buy-and-hold but still had meaningful losses.
3. During the period from about 2004 to about 2015, the traded sleeve had smaller losses than the buy-and-hold.
4. During the period from about 2010 to present, the traded sleeve avoided some of the losses of the NASDAQ buy-and-hold but still tended to underperform the buy-and-hold. Underperforming on a long positively-trending market, and in both periods A and D, is not unusual for the Focused 15 Investing algorithms.

Although not shown as a separate period, one can see in the graph above that the traded sleeve had positive returns in 2020 through 11/27/2020. 

 

Comparison of DJIA and NASDAQ Sleeves

The graph below shows the performance of two sleeves.  The top sleeve (in yellow) is the DJIA sleeve using ETF DDM (DJIA x2).  The next sleeve is the NASDAQ signal set using ETF QLD (NASDAQ x2).  The lower line is a buy-and-hold mix of the DDM and NASDAQ for comparison.  As you can see, the DDM sleeve (yellow) clearly performed better than the QLD sleeve (blue line) up until the end of 2019.  For this roughly 20-year timeframe, the DJIA sleeve had superior returns.  This is especially true just after 2000, where the NASDAQ sleeve had losses (this period was marked “B” in the prior graph).  

The image also highlights the most recent performance in 2020 when the DDM sleeve moves lower and the NASDAQ sleeve moves higher.  This has been unfortunate but can, I believe, be associated with the pandemic and does not necessarily indicate a permanent shift.

If we look at the same sleeves but end the graph 52 weeks ago, we see that the DDM sleeve has a better return and lower variability. 

This is shown by the statistics in the table below. 

Return and Variability (1/7/2000 through 11/29/2019)

                                          DDM                     QLD

  Rate of Return (ann)       28.8%                    26.1%

  Variability (ann)              20.4%                    25.4%

  Ratio (RoR/Var)               1.42                       1.03

 

Now, at the end of 2020, the question is whether NASDAQ-linked ETFs should be included in the regular model portfolios.  My current thought is that 2020 should be viewed an aberration.  If we respond by changing the approach significantly to what would have worked in 2020, we may be poorly positioned for the future.  In addition, we might be simply chasing past performance only to catch price declines associated with correcting the currently high valuations, as in phase B in the graph above. 

If this view is accurate, then gaining exposure to the NASDAQ may be best done using the add-in sleeves in measured amounts as is currently available to subscribers.  The add-in sleeves allow us to move away from the NASDAQ completely during long periods of NASDAQ decline. 

Even if the NASDAQ does indeed represent companies with a more promising future than those in the DJIA, the current economic strains and NASDAQ’s high valuations make it difficult to justify a move to include NASDAQ as a permanent holding in the model portfolios right now. 

As part of ongoing research, I have a range of model portfolios that integrate NASDAQ, and so I monitor this issue.  But the best course of action right now is not to make fundamental changes in the model portfolios. 

end

 

Research Note - Stock Market 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.
• 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.

In the second quarter of 2020, company earnings declined dramatically because of the pandemic, but stock prices increased because Micro MRI shifted to the upleg of its normal cycle and government and Federal Reserve actions began to compensate for the decrease in economic activity and created optimism about an economic recovery.  These changes – a decrease in earnings and an increase in stock price – resulted in high price-to-earnings ratios.  Changes in the price-to-earnings ratio can be temporary because of short-term changes in earnings, such as those occurring in 2020.   

The price-to-book ratio is less sensitive short-term changes in earnings and produces a more stable valuation ratio.  However, in the current environment both valuation ratios are high compared to the last 20 years, suggesting that stocks are expensive. 

The following figure has three panels that plot DJIA data from Bloomberg. 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 38% from the peak of the Internet boom in 2000.
• 2007/8 – Decline of roughly 50% because of the Global Financial Crisis

The second and third panels show the valuation ratios for price-to-earnings and price-to-book ratios, respectively. The horizontal red lines show the current levels of those ratios. Prior to the price trough of October 2002, the price-to-earnings ratio was at a high level – a level similar to today’s.  This data point suggests being skeptical now of further price increases. 

Prior to the decline of 2007/8, the price-to-book ratio was at a high level – a level similar to today’s. This data point also suggests being skeptical now of further price increases. 

However, note that at the far left of both valuation charts, in the late 1990s, levels are higher than the current levels (indicated by the red lines). This was the end of the Internet Boom. 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 stocks that are heavily weighted in the NASDAQ index, including Amazon, Microsoft, Apple, Facebook, and Google.  

While these direct historical comparisons suggest that stocks are already expensive, there are factors that may make these long-term historical valuation comparisons less relevant to the current situation.   They are: 

     Lower Interest Rates

A low interest rate environment tends to support higher valuation metrics.  At the end of January 2000, just as the Internet Boom peaked, the yield on the 10-year US Treasury bond was 6.6%.  That was the rate of return of this comparatively low-risk investment, and made bonds an attractive alternative to stocks for many investors.  In contrast, as of last Friday (December 7, 2020), the yield on the 10-year US Treasury bond was 0.9% - a far less attractive return than 20 years ago.  Thus, investors seeking returns will be less attracted to bonds and more biased toward holding stocks. 

Also, many believe that stock prices should reflect the present value of future company earnings.  The low interest rate today means that earnings further into the future are more relevant to the calculation of present value of future earnings.  A similar effect is seen in a lower mortgage interest rate allowing someone to buy a more expensive house than they could afford at higher interest rate.  Thus, the current extremely low interest rates now may tolerate higher valuation measures without being considered too expensive to purchase.  I mention an article int eh “Alternative Narratives” section below about Jim Paulsen’s view that stocks are very cheap at this point.  He arrives at that conclusion by considering today’s currently low interest rates, among other factors. 

     Fed’s Pledge

 The US Federal Reserve has pledge to keep interest rates very low for a long period of time, and also to buy assets on the open markets to reduce fears about market price declines.  The extent of the current pledge has been extreme:  In early June of 2020, Fed Chairman Jerome Powell said, “We’re not thinking about raising rates, we’re not even thinking about thinking about raising rates," conveying that interest rates are unlikely to increase before 2022, and even then, most in the Fed believe rates to remain low even into 2022 (based on the current plotting of forecasts by Fed members).  https://www.wsj.com/articles/newsletter-were-not-thinking-about-raising-rates-01591872020

     Pent-up Demand May Increase Future Corporate Earnings

Governments around the world have spent billions to compensate for reduced employment and business activity.  Less spending because of the economic shutdown plus the stimulus could conceivably produce pent-up demand.  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. The potential for high future demand is suggested by the personal savings rate in the US, which has moved sharply higher during the pandemic: https://www.statista.com/statistics/246268/personal-savings-rate-in-the-united-states-by-month/. While the saving rate has come down from its April 2020 high, it is still high compared to recent years.  

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

 end