Weekly Note - August 24, 2022

We are still in a Wait season. The next potential Plant season is likely to be in late September.

The Comments section below (not required reading) covers:
1. Current Market Conditions
2. Market Resilience Index (MRI) Conditions
3. Recent Performance

Links included in the text below:

Current Stock Valuations: https://marketresilience.blogspot.com/p/djia-historical-valuation-comparison.html

Historical Inflationary Periods: https://marketresilience.blogspot.com/p/inflationary-periods.html


1. Current Market Conditions (Updated 8/23/2022)

Based on the MRI of a wide range of asset classes (e.g., stocks, bonds, commodities), longer-term investor concerns are shifting away from high inflation toward a possible economic contraction - concern about inflation is still high but is fading. 

At this time, I see DJIA’s recent move higher as the last portion of a counter-trend rally that began in mid-June. The MRI support this view and suggest that stock prices will soon weaken. Many stock indexes have Micro MRI that are very high in their cycles and are shifting to the downlegs of their cycles. I list these and other indexes with their MRI statistics in section 2 below.

Recent business articles have statements similar to this Bloomberg headline of 8/16/2022: “JPMorgan Says the Stock Rally Has Legs. Morgan Stanley Disagrees.” Current MRI dynamics and valuation metrics (mentioned below) support the Morgan Stanley opinion described below. An excerpt from the Bloomberg article:

Top Wall Street strategists are divided on whether the US stock market is poised to extend its longest winning streak of the year -- or slip back after another false dawn.

Morgan Stanley strategists said in a note Monday that the sharp rally since June is just a pause in the bear market, predicting that share prices will slide in the second half of the year as profits weaken, interest rates keep rising and the economy slows. But rivals at JPMorgan Chase & Co. said the rally -- which has pushed up the tech-heavy Nasdaq 100 index by over 20% -- could run through the end of the year.

The schism reflects the highly uncertain outlook for the US stock market in the face of strong cross-currents. On the one hand, inflation is showing signs of pulling back from its peak and businesses have been expanding payrolls at a strong pace, both of which auger well for equities. Yet at the same time, Fed officials have signaled that they will continue to raise interest rates aggressively until consumer price increases are reined in, which risks driving the economy into a recession.

My analysis of valuation ratios for the DJIA supports the more pessimistic view held by Morgan Stanley. The valuation measures of Price/Sales and Price/Book are high by historical standards, and the market is also signaling that we may be in a period of peak earnings; earnings are likely to decline in the coming months. High valuations and potentially declining corporate earnings do not bode well for the stock market, and this is especially true when interest rates are rising. Valuation is not a formal part of our process because of data limitations. Instead, I use it for market context. I have updated an analysis done earlier this year here: https://marketresilience.blogspot.com/p/djia-historical-valuation-comparison.html

While concerns for high inflation and interest rate hikes are receding (for the time being), it is too soon to assume inflation has been tamed. There is a broad range of experiences with inflation over the last 100 years. The most recent period of high inflation was during the 1960s and 1970s, when high inflation persisted for about 18 years. This is probably an extreme case in terms of length. The inflationary period after World War 1 and Spanish Flu pandemic ended abruptly. Other periods of inflation fall in between these.

For historical context, I have added a post, “A Historical Perspective on Past Inflationary Periods,” which shows periods of inflation over the last 100+ years and how the DJIA has performed. It also shows how the MRI-based algorithms we use in the model portfolios performed over different periods. https://marketresilience.blogspot.com/p/inflationary-periods.html

Note about Drivers of Resilience: The MRI drivers I have discussed recently are beginning to indicate a turning point in the Macro MRI, potentially causing it to be less negative. Historically, following the actual Macro MRI has been more successful than following its drivers. However, the drivers give us a view into what may happen in the more distant future. Also, we continue to be in a period of "low investor excitability." During such periods, rapid price changes, either higher or lower, are less likely. 

2. Market Resilience Index (MRI) Conditions

See this link for a description of the language used to discuss resilience: https://focused15investing.com/language.

The DJIA is transitioning to a more vulnerable condition. Last Friday's level of DJIA's Micro MRI moved lower from the prior week; it appears to have begun the downleg of its cycle. Neither the Macro nor Exceptional Macro MRI for the DJIA are providing resilience. These conditions describe a counter-trend rally that is likely to end soon, which means that stock prices are likely to resume the longer-term trend downward established earlier in the year. 

Other US stock indexes are in similar conditions, which reinforces the view that we have indeed been in a broad-based counter-trend rally. All have Micro MRIs at the upper ends of their ranges that are shifting to the downlegs of their cycles. None have longer-term measures of resilience (Macro Exceptional Macro) in the uplegs of their cycles, which makes them vulnerable to declines when their Micro MRIs inevitably make a shift to their downlegs.

Section Updated as of 8/19/2022  
  • DJIA: percentile 82, 83 the prior week. Levels since 1918
  • S&P 500: 92, 93 the prior week. Levels since 1931
  • NASDAQ: 78, 78 the prior week. Levels since 1972
  • Russell 2000: 88, 90 the prior week. Levels since 1985 (small company stocks)
The same is true for these indexes or assets (don’t worry if these terms are not familiar; some people may find these useful):
  • DJ Transports: 81, 81 the prior week. Levels since 1916
  • NASDAQ vs DJIA: 79, 81 the prior week. Levels since 1995
  • Russell 2K vs DJIA: 92, 95 the prior week. Levels since 1995
  • R1K Growth vs Value:  91, 95 the prior week. Levels since 1985 
  • MSCI US Sectors: Cyclical vs Defensive: 92, 94 the prior week. Levels since 1995

Indexes with Micro MRIs moving opposite to those mentioned above:
  • VIX: 6, 2  the prior week. Levels since 1998
  • Credit Spreads: 12, 10 the prior week. Levels since 2002 (Macro MRI is positive)
All the indexes above have Micro MRI at extreme levels, which are likely to revert toward their means in the next few weeks.

3. Performance (not audited)

The US stock market has declined from December 31, 2021 through last Friday. I have calculated the returns that one would get by following instructions since the beginning of the year for the “main” portfolios for each of the publications. Please see endnote for a brief comment on the main portfolios. Contact me with questions.

The year-to-date returns as of 8/19/2022 are:

Diamond: -3.3%
Sapphire: -5.6%

These returns compare favorably to the following alternatives:

DJIA: -6.0%
S&P500: -10.4%
NASDAQ: -18.4%
IEF: -10.1% ETF for the US 7-10-year Treasury bond index, with no leverage

VBINX: -10.9% Vanguard Fund with 60% of assets in stocks and 40% in bonds
VASGX: -12.5% Vanguard Fund with 80% of assets in stocks and 20% in bonds

Endnote: Main Portfolios

The main portfolio in the Diamond publication is sg235. The main portfolio in the Sapphire publication is sg325.

If you use either of these as your long-term portfolio and have followed the instructions since the first of the year by switching to the target weights of a less aggressive portfolio (by following the specification for Box #3, i.e., “-1”) and holding Box #2 Cash as instructed, your account’s performance should be close to the figure above.

Some deviation between your account and the numbers above can be expected. The performance figures above assume trading is done at the close of trading on Fridays. Most people trade earlier in the day. In addition, we sometimes trade before Friday. If you use as your long-term portfolio one that is more or less aggressive than the main portfolio, your actual performance will be different.

The figures above are based on the actual ETFs in the model portfolio. The figures in the weekly publication are based on the index that the ETFs track.