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.