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. 

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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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Weekly Note - October 27, 2020 - Add-in Sleeves

Add-in Sleeves

Using the new add-in sleeves is completely optional. Some will decide to continue doing what they have been doing and not use them. Their current model portfolios will adjust to changes in market dynamics. If you decide not to use the add-in sleeves, simply continue using your current Shares-to-Trade worksheet; the mechanics of the sheet have not changed.

Use of the add-in sleeves is probably best suited to those who are already comfortable trading their Focused 15 investing portfolios.

I think we have a week or two before using the add-in sleeves will have an impact. This is a good time to review them and how they can be used.

My goal in creating the add-in sleeves is to make it easier to move gradually into the ETFs that have been part of the 2020 Recovery portfolios and the Emerald portfolios. The updated Shares-to-Trade worksheet allows you to continue with the model portfolio you are currently using, let’s call it your core model portfolio (or simply “core portfolio”), and at the same time allocate a portion of your account to an add-in sleeve.

On the weekly publications, I list two add-in sleeves. The first is the 2020 Recovery sleeve, which has ETFs linked to technology, healthcare, and communications stocks. The second is the Emerald sleeve, which includes ETFs for green energy and technology.

2020 Recovery Add-in Sleeve

This add-in sleeve focuses on NASDAQ, healthcare, and telecommunications stock ETFs. These ETFs are likely to be favored in the presence of social distancing and government efforts to stimulate economic recovery from the COVID pandemic. This sleeve includes ETFs linked to the tech-biased NASDAQ, the S&P Healthcare sector, and the S&P Communications sector. The ETFs will be dynamically weighted to avoid losses, although some losses will occur. The ETFs included may change over time.

We maintain two versions of the 2020 Recovery add-in sleeve, one for the Zircon, which does not use levered ETFs, and one for the Diamond and Sapphire publications, which use ETF “QLD” that magnifies the return of the NASDAQ 100 two times - essentially giving this ETF twice the market exposure of the NASDAQ 100 Index. Both 2020 Recovery versions have the following exposures to the ETFs (based on equivalent market exposures).
60% NASDAQ (ETF QQQ for the Zircon version and QLD for the Diamond/Sapphire version)
40% A mix of the ETFs VOX (telecommunications) and XLV (healthcare) ETFs

The 2020 Recovery add-in sleeve is designed to a) provide exposure to these sectors, b) avoid losses in the NASDAQ-linked ETFs (using historically tested algorithms), and c) rotate between VOX and XLV to favor the most resilient of these two sectors. This add-in is a good fit for those seeking to invest in sectors favored by the current economic and pandemic conditions.

Emerald Add-in Sleeve

The Emerald add-in sleeve focuses on clean energy and technology stock ETFs and a green bond ETF. This sleeve seeks to take advantage of what many believe is a mega-trend favoring investments in environmental sustainability.

We maintain two Emerald versions, one for the Zircon, which does not used levered ETFs, and one for the Diamond and Sapphire publications, which use ETF “QLD” that magnifies the return of the NASDAQ 100 two times - essentially giving this ETF twice the market exposure of the NASDAQ 100 Index. Both versions of the Emerald add-in sleeve have the following exposures to the ETFs (based on total market exposures).
30% NASDAQ ((ETF QQQ for the Zircon version and QLD for the Diamond/Sapphire version))
25% Clean Energy (PBD)
25% ARK Innovation (ARKK - an actively managed ETF focusing on disruptive technology)
20% Green Bonds (GRNB)

This Emerald add-in sleeve is designed to a) provide exposure to these sectors, and b) avoid losses in the NASDAQ-linked ETFs (using historically tested algorithms) and the Ark Innovation (ARKK) ETF (using a judgmental application of MRI-based disciplines). This add-in is a good fit for those with longer time horizons and/or a strong belief in the presence of the trend toward investments in environmental sustainability and who can tolerate temporary losses. THE EMERALD SLEEVES EMBODY MORE RISK THAN IMPLIED BY THE RETURN-TO-RISK CHARTS ON THE WEEKLY PUBLICATION. Some of these ETFs have short histories and are narrowly focused (PBD is focused on energy-related businesses). Also, this sleeve may be revised over time (including replacing ETFs), which will cause of restatement of historical performance figures.  Links:
   ARKK – Ark Innovation ETF. This is an active ETF, which means that the investment team at Ark buys companies that it believes will benefit from future trends. Website: https://ark-funds.com/arkk
   GRNB - VanEck Vectors Green Bond ETF. Website: https://www.vaneck.com/etf/income/grnb/overview/
   PBD – This ETF tracks the WilderHill New Energy Global Innovation Index. Website: https://www.invesco.com/us-rest/contentdetail?contentId=3dd2fd05f0e21410VgnVCM100000c2f1bf0aRCRD&dnsName=us

Weekly Note - October 14, 2020

Highlights

• A historical perspective on our missing recent market gains
• The current status of the market (DJIA) in terms of longer-term changes in MRI conditions, focusing on the Macro and Exceptional Macro MRI
• A comment about high current stock valuations compared to key points in the last roughly 20 years

Historical Perspective on Missing Recent Market Gains

Our portfolios have fallen behind the market, and one might ask if something in the algorithms are broken.

Focusing on the Diamond (sg131) model portfolio, it has returned -9% thus far year to date. Its Upper Risk Mix (URM) holds the same ETFs at constant weights and and the positions are very aggressive. The URM has returned 1% over the same time period.  Thus, the model portfolio is lagging the URM by about 10 percentage points so far this year. Over the last several weeks, we have been on the sidelines in cash while the market has pushed higher. I watch the markets every day and some days it is painful to see our performance shortfall.

In prior notes, I have described how the markets’ current movements have been distinctive. Specifically, the Micro MRI troughed at a moderate level in mid-July, and, based on historical precedents, the algorithms have stayed out of the stock market ETFs in the subsequent upleg. Yet as of today, this has not been profitable and has contributed to the ten-percentage point shortfall compared to the URM.

Long-Term Performance of the D5 Signal Set 

To provide more historical detail, I evaluated the 100 years of performance for the DJIA signal sets we use and compared the current shortfall (over the last 8 weeks, roughly two months) to all the eight-week rolling periods over the 100 years. The first image should be familiar, and I show it now simply for background.

This shows the DJIA in the brown line. The green line shows the performance of the “D5 signal” set that drives the target weights of the DJIA-linked ETFs (DIA, DDM, UDOW). The performance reflected by the green line does not include bond investments because bonds do not have 100 years of history. Nor does it reflect any leverage that is included in the ETFs DDM and UDOW. Nonetheless, the green line is a reasonable estimate of the value added by the MRI-based signals (based on the Macro, Exceptional Macro, and Macro MRI). The vertical dashed line shows when I started using the MRI-based approach. One can see that the D5 signal set has provided good returns over the 100-year period and also the period of actually being used in portfolios.

At the far right on the green line for the D5 signal set, one can see the recent decline related to the COVID pandemic. The D5 signal set has experienced other declines of similar magnitude and still gone on to produce a strong subsequent performance track record. The years of some of these declines are shown in the chart above.

The Shortfall

The decline in 2020 for the D5 signals set was abrupt and deep (although not as deep as for the buy-and-hold DJIA shown by the brown line). One can see that the buy-and-hold DJIA (brown line) has recovered more fully than has the D5 signal set (green line). That difference creates a performance shortfall of the D5 signal set relative to the buy-and-hold DJIA of roughly ten percentage points since the beginning of 2020.

To give an idea of how common (or unusual) this shortfall is, I have calculated the eight-week shortfalls over the last 100 years. I selected the eight-week (two month) period arbitrarily. The image below shows the performance shortfall over all eight-week rolling periods for the entire 100-year history.



The current shortfall is the third worst since I started using the MRI-based approach in 2007/8, and the ninth worst over the 100 years shown. Thus, the current period of shortfall is not unprecedented. While such a shortfall can be painful, I believe that such a shortfall is insufficient reason to modify the D5 signal set.

Current MRI Conditions – Macro MRI

I often discuss the Micro MRI because that resilience cycle fits most closely the market returns we see each day and week. As mentioned recently, the Micro MRI has been in its downleg over the last few weeks and may trough sometime in November.

In this note, I’d like to discuss the Macro MRI and how it has changed over the last few years. As a reminder, the Macro MRI indicates longer-term resilience with cycles lasting a few quarters to a few years. It is the broad market context that the Micro MRI operates in.

In early 2016, the Macro began a long upleg that lasted until early 2018. Diamond (sg131) had these returns:

  2016    30%
  2017    40%

In January of 2018, the Macro MRI peaked at a remarkably high level. It was at the 98th percentile of its levels since 1918. Since then, it has been in its downleg, indicating that the market lacked long-term resilience. Over the last 100 years, when the Macro MRI is in the downleg of its cycle, there can be deep declines. There can also be periods of strong positive performance for the market and the algorithms seek to capture these returns – but it is more difficult. My notes and comments were influenced by this negative Macro MRI backdrop, resulting in a tentative (rather than emphatic) view that the market would move higher during Micro MRI uplegs, reflecting the difficulty of achieving high returns with low long-term resilience.

  2018    -7%
  2019    33%
  2020    -9% (year through 10/9/2020)

However, today the Macro MRI is now at a relatively low level. It has declined and is now at the 32nd percentile of levels since 1918. This suggests that we are getting closer to a trough of the Macro MRI and a subsequent upleg. The lack of resilience associated with a downleg of the Macro MRI may be coming to an end over the next several weeks or months.

Current MRI Conditions – Exceptional Macro MRI

In the MRI-based framework, the Exceptional Macro plays an important role in the D5 signal set and therefore the target weights of the model portfolios. The Exceptional Macro typically indicates a change in the direction of the Macro MRI (i.e., downleg-to-upleg or upleg-to-downleg). It is sensitive to changes in the slope of the Macro and often foreshadows a peak or trough of the long-term price trend.

The image below shows the Exceptional Macro as vertical green lines on both the price line of the DJIA (upper panel) and the Macro MRI. When it appears, longer term resilience is building and the algorithms tend to favor the DJIA. When it disappears, we tend to avoid investing the DJIA.

Point A is in early 2016 when the market started a strong ascent. Point B is the peak of the Macro MRI and the beginning of a long period of low long-term resilience. The Macro MRI declined until late 2019, when it started moving higher. It did so until the Exceptional Macro appeared briefly at point C, which was just before the COVID-related decline. Between points C and D, the Macro has been in its downleg.

One can see that at points A, B, and C above that the appearance and disappearance of the Exceptional Macro often foreshadows a change in the direction of the Macro. It appeared briefly and then disappeared at point C, which was on January 31, 2020 – well before the Covid crash. A similar appearance/disappearance occurred in January of 2018. As mentioned in prior notes, guidance to adjust Box #2 Cash will be used to reduce losses associated with the disappearance of the Exceptional Macro.

The period from B to D in the image above is similar to the late 1990s when the internet bubble expanded and collapsed. In the late 1990s, NASDAQ and the DJIA moved higher propelled by internet stocks despite the Macro MRI being in the downleg of its cycle. The narrative was that the world would be remade by the internet. As prices moved higher, valuations of stocks moved higher and ultimately came to the point where price increases could not be sustained. When company earnings growth failed to materialize, prices moved lower. As they moved lower, more investors sold, pushing prices even lower.

The take-away from this example is that while we may be getting closer to the beginning of a period of long-term resilience (because the Macro MRI is at a low level – 32nd percentile), the key issue for us is what takes place between now and then.

Current Valuation Levels

While our MRI-based system does not consider valuation (e.g., price-to-earnings, price-to-book), valuation is another useful metric to assess the condition of the market. At this time, the price of the DJIA is high compared to the DJIA companies’ recent earnings and the book value of their assets. I will focus on the price-to-book ratio because earnings are questionable right now, considering the economic shutdown. The current price-to-book ratio for the DJIA is 4.6. This means that for the typical DJIA company, the current price is 4.6 times the recent book value of the company.

The last time this ratio was this high was in late 2007, just before the major decline of 2008. Before that, the price-to-book was this high in early 2000, just as the internet bubble was collapsing. Thus, when the DJIA has been at similarly high valuation measures over the last 20 years, price declines have followed. These valuation measures support us being conservative (low exposure to DJIA-linked ETFs) at this time.  That said, interest rates have been higher over the last few decades than they are now, and today’s very low interest rate environment may simply tolerate higher valuation measures, all else equal.  Thus, I do not consider this valuation level as a conclusive indicator of an imminent major decline.  

Between now and the next period of high Macro MRI resilience, we may experience price declines that move the index toward more reasonable price valuations. While our being out of the market may be painful, there are currently good reasons to stay with the disciplines and wait for the market to be more resilient.

Under Development: Add-In Sleeves

The 2020 Recovery portfolio introduced earlier this year has performed well, but switching to it was too abrupt for many subscribers. The switch would have changed the overall risk profile of their accounts to much for comfort.

I am developing a method to move more gradually into this type of special situation investment. I am creating what I am calling “Add-In Sleeves,” which a subscriber can combine with their current model portfolio in a more gradual way over time. Recall that our model portfolios have “sg” numbers, which refers to sleeve groups, such as the Diamond-Onyx Mix. “Diamond” is one sleeve. “Onyx” is another. I am making it easier for users to add an additional sleeve of their choice.

One add-in sleeve is the “2020 Recovery” sleeve. This is very similar to the 2020 Recovery Portfolio that has been in the publications for several months.

Another add-in sleeve what I call the “Emerald Innovation” sleeve. This is useful for subscribers wanting to invest in longer term mega trends such as the decarbonization of energy and technological innovation.

Users can add one of these sleeves to the current model portfolio using a modified Shares-to-Trade worksheet. They can add, say, 5% or 10% of their account into these sleeves and change this amount over time if desired.

Thus, if you currently use Diamond (sg131) and would like to add in the 2020 Recovery sleeve, you can easily do so. I will describe these sdd-in sleeves after further development over the next few weeks.

Please note that these new capabilities will not require you to change what you are doing.

J

Weekly Note - August 26, 2020 - Performance Review, NASDAQ Valuation

 This post contains:

·        Performance Review of 2020 model portfolio performance compared to the DJIA

·        An explanation for why the model portfolios are lagging the DJIA. This section includes charts showing concepts I have explained in text in weekly notes about the progressively higher troughs in the Micro MRI cycles over the last few years

·        Current Valuation of the NASDAQ index that is an important part of the 2020 Recovery portfolio.  This section explains why I believe it is too late in its short-term resilience cycle to switch to this portfolio

Note: I will discuss additional MRI shifts that signal greater longer-term resilience in an upcoming post.  

Performance Review

For this year, unfortunately, the performance for the model portfolios is flat or negative.  The figures in the first column are for the period from Friday December 27, 2019 through Friday August 21, 2020.  Those in the second are for the six-year period beginning at the inception of Focused 15 Investing - they are presented for a longer-term perspective.   

RATES OF RETURN 

                                                                   December 27, 2019     July 18, 2014 -

                                                                     August 21, 2020        August 21, 2020

Diamond uses DJIA-linked ETF “DDM”

  Diamond (DJIA x2) – 3 ETFs (sg131)                -9%                            14%

  Diamond-Onyx 35-65 Mix – 5 ETFs (sg218)       0%                            13%

 

Sapphire and Emerald use DJIA-linked ETF “UDOW”

  Sapphire-Onyx 50-50 Mix - 4 ETFs (sg299)       -8%                           21%

  Emerald-Onyx 50-50 Mix - 5 ETFs (sg301)        -8%                           20%

 

Comparison

  Dow Jones Industrial Average (DJIA)                -1%                          11%

 

Thus, our portfolios have returned about 7 or 8 percentage points less than the DJIA for this year.  However, most of this underperformance has occurred over the last nine weeks, since June 19, 2020.  As of June 19^th, the “Diamond (DJIA x2) – 3 ETFs (sg131)” had returned -10% while the DJIA returned -9%. Although our defensive posture from June 19 through August 21 caused us to miss out on some gains, I believe there have been sound reasons for this defensive posture.  I’ll break this 9-week period into to two sub periods.   

From June 19^th through July 17^th there were no sources of resilience.  All of the MRI were in the downlegs of their cycles.  Thus, the algorithms called for low exposure to the DJIA-linked ETFs.  The DJIA climbed during this period, which can happen even when there is no resilience if there are other mitigating factors.  In the current situation, I believe both the government stimulus and the Fed’s commitment to keep rates low for a long period of time have created support for stock prices in the face of an abrupt economic contraction.  

On July 17^th (six weeks ago), the Micro MRI somewhat unexpectedly formed a trough at a relatively high level and shifted to the upleg of its cycle.  I’d like to show graphs that help explain my past comments on this inflection point in the Micro MRI and why we might miss some of the positive returns of the DJIA associated with this upleg of the Micro MRI.  In the note a few days later (on July 22^nd), I stated

Going forward, one possibility is that the Micro MRI moves higher for a few weeks, taking prices higher than the June highs.  If this is the case, we will have to wait several weeks to assess the potential of a second bottom of the W-shaped market recovery pattern.

 That move has taken place.  In a note sent out August 8, I stated:

Over the last 100 years, there have been many instances of the Micro MRI forming a trough at a moderate level (at roughly the 50th percentile).  In the research that led to the current algorithms, I found that when there is a trough at a moderate level, the subsequent trough may come more quickly and be particularly deep.  This would imply that the DJIA stock prices would move higher for a short time over the next several weeks and then decline to a low level.  This type of delayed and exaggerated decline did not always follow this pattern (i.e., trough at a moderate level), but it did often enough that it is best (from a portfolio-level risk-and-return point of view) for the algorithms not to move aggressively back into the market when the trough occurs at roughly the 50th percentile.  Instead, it is best to wait for that subsequent deeper downleg to occur before moving back into the market. 

Thus, all else equal, we will have low target weights for the DJIA-linked ETFs for the next few weeks.  Of course, if the Exceptional Macro or the Macro MRI move to the positive legs of their cycles or other metrics indicate stronger resilience, the target weights will reflect those changes.

The following images illustrate these ideas.  In the image immediately below, the DJIA price appears on the upper panel. The Micro Market Resilience Index (Micro MRI), which measures the bursts of resilience lasting 5 to 15 weeks, is on the lower.  The Micro MRI moves around the horizontal blue line, which approximates the 50^th percentile level.  The pandemic-related troughs (March 20, 2020) in each panel are labelled. 

(Contact use for the image: https://focused15investing.com/contact)

As of March 20, the Micro MRI formed a deep trough (at less than the 1^st percentile of levels since 1918, meaning it was at the lowest extreme) and indicated a high likelihood of the DJIA moving higher as the Micro MRI moved to the upleg of its cycle. The DJIA did indeed move higher after that trough.  

The next trough in the Micro MRI, which occurred on July 17, was noteworthy and surprising. It was noteworthy because it happened at a relatively high level – at about the 50^th percentile.  The troughs are more typically much lower at around the 15^th percentile.  As mentioned above, when there is a shallow trough, the following Micro MRI trough and price decline tend to be deeper.  This pattern does not always take place, but it does take place often enough that it is best not to chase prices higher.  This is programmed into the algorithms. Thus, the current underperformance of the model portfolios is consistent with the algorithm exercising caution in these circumstances.

The impact of not having exposure to the DJIA-linked ETFs is clearly evident in the performance of the model portfolios that focus primarily on the DJIA-linked ETFs.  The chart below shows the returns of the Diamond (sg131) model portfolio compared to the DJIA since July 18, 2014 (the inception of Focused 15 Investing). 

As you can see, the return of the model portfolio (represented by the blue line) has been flat for several weeks, while the DJIA has moved higher.

For model portfolios that combine the Onyx sleeve with Diamond, the adverse impact being out of the DJIA-linked ETFs this last several weeks has been muted.  The Diamond-Onyx 35-65 Mix (sg218) is a mix of 35% Diamond and 65% Onyx (consisting of four low variability ETFs) and it has a slightly different pattern.  It is represented by the blue line below, which, as one can see in the chart below, moves higher (instead of being flat) over the last several weeks because of the Onyx sleeve’s exposure to ETFs tracking consumer staples and utility stocks. 

Progressively Higher Troughs in the Micro MRI Beginning in 2018

I mentioned that the most recent trough was surprising. It is surprising because it seems to continue a pattern of progressively higher troughs that began in early 2018.  The chart below shows the progressively higher troughs in Micro MRI beginning in early 2018. (Obviously, the COVID-related trough in March of 2020 is an exception to this trend.)

(Contact use for the image: https://focused15investing.com/contact)

 

This 2 ½ year pattern suggests a progressively shorter period of vulnerability and pessimism during the downleg of the Micro cycles, with the March 2020 decline being an exception. 

After the decline in March, I thought that pattern of progressively higher troughs had ended.  But now, it seems that prices might reflect a growing and unsustainable level of optimism. 

Recall that the Micro MRI measures the short-term bursts of market resilience and optimism and the inevitable bursts of vulnerability and pessimism that follow.  I believe these cycles are inevitable because the fair value of the index can never be determined with certainty.  “Fair value” is a function of many variables, including future economic growth, inflation, interest rates and, currently, the pandemic.  Investors as a whole as represented by the market indexes make guesses about fair value, and their guesses tend to overshoot and undershoot fair value on a regular basis as they try to determine it.  The cycles are created when prices move ever higher, to the point where increases are far above the fair value of the index. When continued price increases become unsustainable, prices move lower.  Prices then decline as investors as a whole try to determine a fair value perceived to be lower than the current price.  They typically overshoot fair value as vulnerability and pessimism set in.    

When the period of pessimism is truncated at a high level (i.e., when the troughs occur at high levels, as they have been doing), it is an indication that the market is either (a) identifying a higher level for the fair value, or (b) the market is becoming overly optimistic (or delusional) about the future growth of the economy and/or other factors that are used to determine fair value.  There are examples of both (a) and (b) over the last 100 years. 

The algorithms are designed to be conservative in this situation; that is, they do not chase prices higher after a shallow inflection point. Subsequent price declines may be deep and abrupt.  This conservatism has been the better course of action over the last 100 years.  However, this conservative stance has not been rewarded thus far in 2020. 

The case for this being a period of excessive optimism is supported by the following valuation information for NASDAQ and the high recent returns of a small group of stocks discussed below.    

Current Valuation of the NASDAQ 100 Index:  Too Late to Get Into for this Cycle

The NASDAQ 100 index has had strong performance since the end of 2019.  From 12/27/2019 to 8/21/20202 (last Friday), it returned 32%, which is much higher than the -1% return for the DJIA mentioned at the beginning of this note. 

The NASDAQ 100 ETF “QLD,” which gives two times the return each day, is a key part of the 2020 Recovery portfolio: Diamond-Onyx 35-65 Mix ‘2020’ - 5 ETFs (sg218.2).  This model portfolio has returned 13% over that same period.  As much as I would like to have everyone get the high returns of the NASDAQ in the recent market, I believe it is too late in the Micro MRI cycle to move into this model portfolio right now.  

The Micro MRI for the NASDAQ 100 index is at the 74^th percentile, indicating that it is currently in the upper portion of its normal range.  While the algorithms are intended to reduce the target weight of this index when its MRI approaches a peak, the algorithms may not avoid all losses when the Micro MRI finally does peak.  The NASDAQ has a history of large decline occurring abruptly.  The current target weights for “Diamond-Onyx 35-65 Mix ‘2020’ - 5 ETFs (sg218.2)” indicate a relatively small allocation of 6% to QLD compared to a maximum allocation of 15% for that model portfolio.  Of course, any subscriber can decide on their own to use the Recovery portfolio, but I can give guidance for everyone to make this switch.  

A look at current valuation measures reinforces that the NASDAQ is at high price levels.  A common valuation measure is called the Price-to-Earnings ratio (PE ratio).  This indicates the price compared to recent annual earnings.  As of last Friday, the PE ratio was 37 for the NASDAQ 100, meaning that the price is 37 times recent annual earnings.  The index ended 2019 with a ratio of 27, and the ratio dropped to 21 in March of this year.  Unfortunately, one cannot determine the PE ratio that represents a fair value because it depends on future growth, interest rates, inflation and other factors.  So, we look at the past for reference.    

As a comparison, NASDAQ’s PE ratio was 33 at the peak of the index (10/26/2007), just before the Global Financial Crisis. After that date, the NASDAQ 100 price level dropped by about 52%.  I am not suggesting a drop of the same magnitude, but I am saying we may be closer to the top of the short-term cycle than the bottom.  Differing interest rate environments across time weaken some of these comparisons.  For example, the yield on the 10-year Treasury bond was about 4.5% at the end of 2007.  Today it is at about 0.7%, and so today’s low interest rate environment may justify higher PE ratios, all else equal.  This is where the MRI are useful in comparing cycles across time.  The Micro MRI is currently at the 74^th percentile of levels since 1972 (the beginning of the NASDAQ Composite).  If we assume that the short-term peak of prices and the Micro MRI is at about the 85^th percentile, we might have a few weeks of prices moving higher before prices move lower due to a lack of short-term resilience.  

Thus, I believe there will be a better time to use the NASDAQ later on.  Further, I am evaluating how NASDAQ can be included in the regular model portfolios.  More on this later. 

As further evidence suggesting the wisdom of not chasing the NASDAQ, consider the following article from Bloomberg news.  The stocks mentioned below are heavily weighted in the NASDAQ index.  You have heard of different letters to describe marked patterns (e.g. V, W, L). The article referenced below describes a K-shaped market recovery (what makes it look like a K is described below).  It says that the current wide gap between the return of internet/tech companies that are heavily weighted in NASDAQ such as Facebook, Apple, Amazon, Netflix, and Google (called the FANG or sometimes FAANG index) and the broader market is a sign of an impending market crash. The case for big price gains for the FAANG group of companies is that pandemic-related lockdowns drive business to these internet and high tech businesses. 

https://www.bloomberg.com/opinion/articles/2020-08-25/k-shaped-stocks-recovery-has-fangs-that-may-bite-investors

The blue line rising steeply since the March 2020 lows is the FANG index.  The black line represents the Russell Top 50 (an index of the largest 50 companies in the US).  The growing gap represents the arm and leg of the K.  (The Russell 2000 of small company stocks, is also shown). The article states:

… it is generally a sign that a trend is reaching a peak… When extreme inequity is this obvious and this widely applicable, we’ve reached the point where the arm and the leg of the K are more like alligator jaws, primed to snap closed. 

The message of this article is that the gap between FAANG (and NASDAQ) and other indexes will close.  Some researchers say that the price of FAANG stocks will drop dramatically when there is progress on treatments and vaccines for COVID.  Further, the article predicts that the drop in FAANG will also cause a drop in the broader indexes.   

 

I believe the current price of NASDAQ is far in excess of fair value.  I also see the MRI conditions for the DJIA improving.  The NASDAQ may move down and the DJIA may move up as the jaws of the K close.  The algorithms are likely going to wait for a stronger signal to move back in the DJIA-linked ETFs.  Until then, the model portfolios will be defensive. 

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Weekly Note - July 15, 2020 - 2020 Recovery Version of Existing Model Portfolios

I have added a new portfolio that takes the place of the 2020 Recovery Portfolio (sg117) that I introduced a few months ago. Like the 2020 Recovery Portfolio (sg117) that it replaces, the new version gives a prominent role to the NASDAQ. The new 2020 recovery portfolio is a blend of a main model portfolio in the publication and the original 2020 Recovery portfolio (sg117). It includes not only a DJIA-linked ETF (like virtually all Focused 15 portfolios) but also a NASDAQ-linked ETF.

The new recovery portfolio version is labelled:

  - Diamond-Onyx 35-65 Mix (Main) 2020 (sg218.2)

Note that the sg number for this new recovery portfolio ends in “.2” (point two) to distinguish it from the model portfolio “Diamond-Onyx 35-65 Mix (Main) - sg218” that it is based on. Also note that the portfolio name ends with “2020.”

Another feature of the new version is the omission of the ETF SHY (US Treasury 1-3 year bond ETF). Instead of trading SHY, one simply holds that same amount of money uninvested in one’s account – the amount being indicated as “Cash (no ETF)” in the weekly target weights. This omission of SHY allows the addition of the NASDAQ-linked ETF without increasing the number of ETFs.

Below is a diagram that compares Diamond-Onyx Mix (sg218) and the new 2020 recovery (sg218.2) version.

The maximum exposure to sleeves (green boxes) with the high-volatility equity indexes (DJIA and NASDAQ) is the same—35 percent for both the main model portfolio and its 2020 recovery version. In the recovery version, the NASDAQ occupies a share of that 35 percent. There is a “minimum” of 65 percent allocated to the Onyx sleeve (yellow boxes) of the portfolio. The values shown in the Onyx sleeve are the neutral positions for those ETFs. The weekly target weights for all ETFs vary over time.

Why NASDAQ Was Not Used Earlier

A reasonable question is why NASDAQ was not included in the original Focused 15 Investing model portfolios. In the period 2007 to 2010, when the MRI approach was developed, NASDAQ’s history was just 36 years (beginning in 1971) and much of that history was dominated by the internet and technology boom of the 1990s and the following bust in 2000.

The MRI did a reasonable job navigating that boom and bust, but it was just one major cycle in the historical record, and therefore I was not able to conclude with confidence that the MRI approach was successful for NASDAQ in general. By comparison, the DJIA has usable history back to 1918 and has had many booms and busts during that time. The MRI did a good job of navigating them, which gives greater confidence in the DJIA signals.

But now, we have had additional valuable experience with the MRI and NASDAQ. Not only have the MRI handled the NASDAQ well for the period prior to the 2007-2009 financial crisis, but also the years though 2020 (thus far).

When we are well past the pandemic, we may see that the there is a place in the main portfolios for a NASDAQ ETF, or we may find that we can revert to using just DJIA. That decision, however, comes later – perhaps many quarters from now.

Additional Thoughts on SHY

In my own investing and from discussions with subscribers, I see that people favor trading fewer ETFs. As you may know, many of the model portfolios use the ETF SHY, which is for 1-3 year Treasury bonds, and is our most conservative ETF. From 2000 to 2010, SHY had an annualized return of 3.9%. This is a good return for a very low risk investment. However, from 2010 to 2020, SHY had an annualized return of 1.2%. The Fed has recently said that it will keep interest rates low for the foreseeable future and this decision means that the return of SHY may stay low. For us, it may not be worth the effort to SHY for the next few years. Thus, the new portfolio does not use SHY – instead the same amount of money is simply held in your account uninvested. This amount is indicated as “Cash (no ETF)” in the target weights. If interest rates move higher, we can switch back to using SHY.