Weekly Note - October 25, 2023

This note covers:

  • Current market conditions as indicated by the Market Resilience Indexes (see link for descriptions) and our new Risk Tolerance Drivers (discussed below).
  • Comment about select ETF holdings

The stock market has the following conditions:

  Negative for stock prices -
  • The MRI indicate that the short-term (Micro) and long-term (Macro) trends for stock prices (DJIA) are now negative. The Macro MRI could remain in the downleg of its cycle for several months.
  • Our new risk tolerance drivers (described below) indicate that risk tolerance will decrease over the coming weeks and months, supporting the negative trend indicated by the MRI. Risk tolerance will decrease more dramatically after the end of November. 
  • Stock valuation measures remain high and interest rates are high, which put downward pressure on stock prices, all else equal.

   Positive for stock prices -

  • The potential for a counter-trend rally in stock prices (this condition is causing our algorithms to continue to hold the DJIA- and NASDAQ-linked ETFs). While this is a positive dynamic, it is short-term in nature.
Since the only positive current dynamic is transitory and is not likely to last as long as the negative dynamics, it is prudent to continue to reduce risk in our portfolios by raising Box #2 Cash in advance of what the algorithms indicate. 


The stock market is continuing its recent shift to lower resilience and has established a negative long-term price trend. The Macro MRI and Exceptional Macro MRI ceased indicating a positive price trend a few weeks ago and did so more decisively than has been the case over the last year. The MRI are based on our proprietary measures of index return acceleration and thus are affected by current events and naturally occurring cycles of optimism.  

You may recall from prior notes that the positive long-term trend in stock prices since last September has been weak by historical standards:
  • The Macro MRI, which indicates the long-term trend of stock prices, has moved almost horizontally for about a year. It is more common for it to move more steeply up or down.
  • The Exceptional Macro, which appears when the Macro MRI is likely to develop a more positive slope, has been off and on over the same period. It typically changes status more decisively.
Thus, the price recovery over the last year has been abnormally weak making the recent shift to a more negative trend unsurprising. We are now in a period in which the long-term trend of prices is negative, which is a bear market using our definition.

The Micro MRI, which measures the shortest cycle of resilience is still in the downleg of its cycle. This means that none of the three MRI are providing resilience at this time. In many similar situations, the algorithms would call for zero weight in the DJIA-linked ETFs. The reason they do not do so now is because the Micro MRI is at a very low level, at the 19th percentile of levels since 1918. We can reasonably expect the Micro MRI to reach its trough and then move to the upleg of its cycle over the coming weeks. 

When the Micro MRI does shift to its upleg, the short-term rally will begin. Yet, because the Macro MRI (indicating the long-term trend of prices) is in the downleg of its cycle, the rally will be a counter-trend rally. Such rallies typically end quickly and prices then decline to a level lower than when the rally started. 

The algorithms are expecting this shift and a short-term move higher in stock prices. They suggest we continue to hold the DJIA-linked ETFs. On average over the last 100 years, the algorithms have been successful participating in counter-trend rallies and getting out in time to avoid the major declines. For this reason, the target weights for the DJIA are positive. The weight of these ETFs may increase after the Micro MRI has indeed shifted to the upleg of its cycle. 

The current MRI readings suggest that the counter-trend rally will not be sufficiently strong to change the trend of the Macro MRI to positive from negative. If this continues to be the case increasing our allocation to cash prior to the end of November will be appropriate for reasons discussed below.   

    Risk Tolerance Drivers

Our recent research on the natural cycles of investor optimism has enabled us to forecast what we call collective investor risk tolerance. Investor risk tolerance describes when investors collectively put a positive (high risk tolerance) or negative (low) spin on any events that take place. Our risk tolerance forecasts are based on variables that are independent of and exogenous to the markets. 

In general, the risk tolerance forecasts indicate potential positive and negative inflection points in the MRI that will be realized if there is an economic need for a meaningful adjustment in stock prices. In our analysis of major market declines over the last 100 years, the Market Resilience Indexes give (as you know) advanced notice of most major stock market declines, and the risk tolerance drivers give advanced warning of the important shifts in the MRI. Thus, changes in the risk tolerance drivers typically precede the changes in the MRI. 

Because of the exogenous variables we use, we can forecast risk tolerance further into the future than we can forecast the MRI. Thus, the drivers indicate when investors are likely to put a positive or negative spin on current events, and the MRI say when they have done so and to what degree. 

The current risk tolerance forecasts are:
  • Short-term risk tolerance was forecast to begin decreasing from the end of September (a few weeks ago) through mid December. We have already seen this shift in recent stock price declines. 
  • Long-term risk tolerance is likely to decrease more sharply beginning the end of November.
As discussed in a later section, the stock market is under a relatively heavy economic load because valuations and interest rates are high. These conditions likely constitute an economic need for lower stock prices. We expect the market to continue to respond to shifts in collective investor risk tolerance over the next few months.  

An important finding from our analysis of the risk tolerance drivers over the last 100 years is that, over the recent roughly two-year period (2022 and 2023 to date), the DJIA has followed the long-term (Macro) risk tolerance driver and the Macro MRI far more closely than it has over most other two-year periods. Especially over the last year, the DJIA has essentially ignored the Micro MRI. Should this behavior continue, the approaching upleg of the Micro MRI may have a lower than usual impact on stock prices and make the expected counter-trend rally weaker than normal. In addition, the expected negative shift of the long-term (Macro) risk tolerance driver at the end of November may precipitate a dramatic decline in prices. 

Another important feature of the current environment is that the Macro MRI has shifted to the downleg of its cycle IN ADVNCE of its risk tolerance driver. As mentioned, the risk tolerance driver typically precedes the MRI. But in the current situation, the Macro MRI has already shifted to its downleg, presumably responding to negative market conditions. This pattern also occurred in 2007 and was followed by the dramatic declines of 2008. During that period, the Macro MRI successfully indicated the peak of stock prices and then moved to the downleg of its cycle. During the downleg of the Macro MRI, the DJIA experienced a series of counter-trend rallies. However, the major decline in stock prices occurred just after the long-term (Macro) risk tolerance driver shifted to the downleg of its cycle. If that pattern is applicable today, major declines would occur in late November or December.   

For now, both the MRI and the risk tolerance drivers are now flashing warning signs. Holding Box #2 Cash is prudent at this time. There will be a better time in the future to be aggressive. 

    High Economic Load on the Stock Market

The economic load on the stock market is currently high because of elevated valuation levels and high interest rates. The important ratios of Price-to-Book and Price-to-Sales for the DJIA are high relative to levels since 1997. For both ratios, the current level is at about the 80th percentile of levels since 1997. The same is true for the Price-to-Earnings ratio.

The Price-to-Book and Price-to-Sales ratios at the at prior market bottoms have been meaningfully lower than current levels, as shown in Figure 1 below.

Figure 1 

Other measures that contribute to the high economic load on the stock market are the high Fed Funds rate, high yield on US 10-year Treasury bonds, and the relatively low yield on stocks. The Fed Funds rate is high and has only been higher (since 1997) in 2006 and 2007, just prior to the decline of late 2007 and 2008.  The ratio of the yield of the US 10-year Treasury bond to the dividend yield of the DJIA is high and only exceeded this level during that same 2006 and 2007 period. Since the Fed has vowed to keep rates high to combat inflation, the Fed Funds rate is not likely to reduce rates until inflation is lower (which may be associated with lower economic growth). Our MRI metrics for the yield on the US 10-year bond indicate that it is not yet ready to move lower.  Thus, the economic load on the stock market remains elevated.  

    The Positives for the Stock Market

Supporting high stock prices are high economic growth and the historically low current unemployment rate. The recent quarter showed US GDP growth to be 4.9% (this number reflects the quarterly growth rate on an annualized basis). This is a high rate by historical standards. 

The current reading for the unemployment rate is 3.8% and this is a low level by historical standards. Figure 2 below shows the US unemployment rate from 1948 through the most recent month. The heavy blue horizontal line shows the current level.

Figure 2

The large spike on the right is the COVID period. As you can see, just a few periods had unemployment rates as low as the current rate (2019, early 2000, and the late 1960s).

Another plus for stock prices is that stocks are a good hedge against inflation. Stocks tend to hold their value during inflationary times better than bonds. After the initial shock of high inflation hurts stock prices, stocks often perform well. During the 1970s when inflation was high for several years and the MRI navigated the period well. Especially if there is no increase in the unemployment rate, we are likely to find stock ETFs attractive if inflation persists. 

Another factor that might support high stock prices, at least indirectly, are the wars in Ukraine and the Mideast. The Fed may soften its war on inflation and may cut rates sooner than it otherwise would to avoid supporting these conflicts during an economic recession.

Other Portfolio Holdings

Commodities (e.g., oil, gas, corn, wheat, silver, gold) tend to hold their value during inflationary times. Yet, the MRI for the major commodities indexes indicate lower resilience going forward. Over recent weeks, the Macro MRI has been in the upleg of its cycles and the Exceptional Macro has been present. As of last Friday, the Exceptional Macro ended and the Macro, while still in its upleg, is poised to shift to its downleg. These changes suggest that economic growth may slow. Our commodities ETF “COM” has not been sufficiently resilient for it to receive a higher weight in our portfolios. The recent upward swing of the commodity index has not translated into sufficient positive price trends for the individual commodities COM holds. Thus, we have not held our highest possible allocation to COM. Going forward, the algorithms are more likely to suggest holding a higher weight in COM if inflation remains high and economic growth remains strong, but that set of conditions now appears to be less likely than slowing inflation and slowing economic growth.

Our ETFs linked to US 10-year Treasury bonds (UST and TYD) are still vulnerable to declines. If the economy appears to the Fed to be poised to slip into recession, it may cut interest rates, which will provide resilience to these bond ETFs and we would increase allocations to these ETFs accordingly. Some market commentators are saying it is time to hold more in these investments. The MRI suggest that such a move is premature.

Our Bitcoin ETF (BITO) has moved higher. It has additional upside potential. The Macro MRI is in the upleg of its cycle and the Exceptional Macro appeared on September 29, both of which indicate a positive long-term trend in prices. The current target weight is designed to result in a roughly 5% weight in our accounts considering the allocation to Box #2 Cash. This target weight may increase to accommodate positive price moves.