Weekly Note - January 11, 2023 - Update of Valuation Ratios and Corporate Earnings

 The note below covers:

1. Valuation Ratios for the DJIA are Still High
2. Corporate Earnings Have Not Yet Come Down

1. Valuations for the DJIA are Still High

Stepping outside the MRI framework, the valuations of the companies in the DJIA are still high compared to their valuations between January 2000 and last Friday (1/6/2022). Figure 1 below shows the current ratios and historical reference points. Please see this page for a brief description of these ratios.

Figure 1

The Price/Book (P/B) and Price/Sales (P/S) ratios are most important for this discussion. They are still high compared to the range of values since January 2000. As one can see in Figure 1, the percentile rankings of the current values are both above the 90th percentile. These figures mean stocks are expensive based on recent actual book values, sales, and earnings.  

In order for these high levels to be justified, corporate earnings growth will need to be strong going forward. In a time of slower economic growth induced by the Federal Reserve with higher interest rates, an outlook for especially strong economic growth does not seem to be the most likely scenario.  

Historically, these valuation ratios are low at market bottoms, and the ratios are shown for three recent market bottoms. DJIA prices will need to fall further to achieve those levels. In my elaboration of the industry adage “A Bull Market Climbs a Wall of Worry,” point #3 is relevant here – the current high valuation ratios suggest that stock prices will fall more than they already have.   

2. Corporate Earnings Have Not Yet Come Down

Figure 2 below shows the price of the DJIA (log scale, brown line), with the Peak-Earnings Indicator (PEI) in yellow. Last Friday is at the far right. The current major decline of the DJIA, which began in December of 2021, is indicated by “D”. The PEI has signaled that corporate earnings have been abnormally high throughout much of 2022. While earnings for the companies in the DJIA (shown by the double blue line) have declined somewhat since the mid-2022, they not yet declined as much as they have after the prior declines A, B, and C. Note that the declines in actual earnings typically occur several months AFTER the PEI has itself peaked.  

Figure 2

If historical patterns hold true, corporate earnings are likely to continue to decline further from here. If you would like to read my discussion of the PEI, I describe it here.

Based on the PEI and this analysis, the effects of a recession have not yet been seen in corporate earnings. Corporate earnings are likely buoyed by the ample Covid stimulus still in the system. That stimulus is helping to drive inflation, and the Fed is trying to dampen the effects of that stimulus. Thus, the economic battle between inflation and recession continues.

Weekly Note - November 30, 2022

The note below covers:

1. Market Comment
2. Current Valuation Ratios
3. Conclusion
Note 1: Corporate Earnings Have Not Yet Come Down

1. Market Comment

The short-term cycle of resilience (measured by the Micro MRI) for the DJIA was at the 82nd percentile of levels since 1918 as of last Friday, which is a high level. The computer models and historical precedents continue to indicate that the recent move higher in the stock market is likely to be temporary and stock prices (as tracked by the DJIA) will be more vulnerable to declines when the Micro MRI moves to the downleg of its cycle. Please see this page for the language used to describe the MRI cycles: https://focused15investing.com/language

The Macro MRI, which indicates the longer-term trend of the stock market, is becoming less negative. In addition, the Exceptional Macro is very close to appearing for several stock market and bond market indexes. If these do indeed change, they would indicate a bullish view of the stock market (stock prices continuing higher) that could last several quarters or longer. As this shift takes place, we must recognize that the low point of this market decline might have already taken place at the end of September (when the Micro MRI began its upleg). At that time, there was little indication that these positive shifts might take place soon.

Nonetheless, the computer models and algorithms indicate that stock prices (as measured by the DJIA) are likely to be more vulnerable to declines over the coming weeks when the Micro MRI inevitably moves to the downleg of its cycle. Thus, our portfolios are still defensive. Qualitatively, I believe there will be a better time in the future for our portfolios to be aggressive. This view is supported by the high valuation ratios of stocks.

2. Valuations for the DJIA are Still High

Stepping outside the MRI framework, the valuations of the companies in the DJIA are still high compared to their valuations between January 2000 and last Friday (11/25/2022). Figure 1 below shows the current ratios and historical reference points. Please see this page for a brief description of these ratios.

Figure 1

The Price/Book (P/B) and Price/Sales (P/S) ratios are most important for this discussion. They are still high compared to the range of values since January 2000. As one can see in Figure 1, the percentile rankings of the current values are both at the 93rd level in this time period. These are high figures meaning stocks are not cheap based on recent actual book values, sales, and earnings.  These figures say stocks are expensive.

In order for these high levels to be justified, corporate earnings growth will need to be strong going forward. In a time of slower economic growth induced by the Federal Reserve with higher interest rates, an outlook for especially strong economic growth does not seem to be the most likely scenario.  

Historically, these valuation ratios are low at market bottoms - closer to their average valuation ratios indicated above (their 50th percentile rankings). DJIA prices will need to fall further to achieve those levels. In my elaboration of the industry adage “A Bull Market Climbs a Wall of Worry,” point #3 is relevant here – the current high valuation ratios suggest that stock prices will fall more than they already have. While not shown, the P/B and P/S ratios for the S&P 500 stock index are also high rating at the 85th and 92nd percentiles, respectively.  

3. Conclusion

The markets have been transitioning over the last several weeks and I expect them to continue to do so for the next few weeks. The markets are undergoing a shift from investor concerns being focused on inflation and high interest rates to a concern about recession and high valuations. However, instead of the market moving straight from a) inflation fear, to b) recession/valuation fear, the market seems to be going through an intermediate step: a) inflation fear, to b) everything will be OK (soft landing), to c) recession/valuation fears. A soft landing means that the Fed slows economic growth to curb inflation but does not push the economy into recession. Historically, soft landings have been difficult to achieve.  

Currently high valuation ratios support the potential dominance of c) recession/valuation fears.  Yet, the MRI are starting to signal an “OK-soft landing” for now. We had a similar situation in the early 2000s, and there was a further decline after a “OK-soft-landing” period of a few months, which the MRI identified. This view is supported by the Peak-Earnings Indicator analysis described in note 1 below. As the transition becomes clearer, we will move either way – becoming more or less aggressive. 

Note 1: Corporate Earnings Have Not Yet Come Down

Figure 2 below shows the price of the DJIA (log scale, brown line), with the Peak-Earnings Indicator (PEI) in yellow. Last Friday is at the far right. The current decline of the DJIA, which began in December of 2021, is indicated by “D”. The PEI signaled that corporate earnings are abnormally high throughout much of 2022, but earnings for the companies in the DJIA (shown by the double blue line) have not yet declined as far as they have after the prior declines A, B, and C.

Figure 2

If historical patterns hold true, corporate earnings are likely to continue to decline further from here. You can also see that the declines in earnings take place several months after the PEI has peaked. If you would like to read my discussion of the PEI, I describe it here.

Based on the PEI and this analysis, the effects of a recession have not yet been seen in corporate earnings. Corporate earnings are likely buoyed by the ample Covid stimulus still in the system. That stimulus is helping to drive inflation, and the Fed is trying to dampen the effects of that stimulus. Thus, the economic battle between inflation and recession continues and we appear to be lull between the two extremes.

Weekly Note - October 26, 2022

The note below covers:

  1. Market Comment
  2. New Page – Repeated from Last Week’s Note
  3. Performance

1. Market Comment

As expected, the stock market has moved higher since the end of September. The move higher is likely a counter-trend rally, which is when prices move higher temporarily and then fall to a lower level than when the rally began.

As you may recall, the timing of this move higher is not a surprise; it is consistent with the projected movements of the Micro MRI. Since the beginning of 2022, the Micro MRI has generally followed its projected path. If the DJIA continues to follow the projected path, the current counter-trend rally will end in early November. Stock prices are then likely to be less resilient through the end of this year.

In addition to the projections calling for further price declines in a few weeks, the computer models and algorithms based on the MRI also are very cautious about the mid-term outlook for stocks. The following points describe the MRI conditions for the DJIA as of 10/21/2022. Please see this link for a discussion of our terminology: https://focused15investing.com/language

• The Macro MRI has been in the downleg of its cycle since mid-December 2021, when it peaked at about the 80th percentile. The downleg continues and shows no sign of ending. A shift to the upleg of the Macro MRI cycle will be a strong indicator of the end of the current bear market.
• The Macro MRI has declined to a low level. It is at the 32nd percentile of levels since 1918. The decline of the Macro from its recent peak at the 80th percentile to the current 32nd percentile has been quite steep. While I do expect it to decline further, we are coming closer to the inevitable end of the decline.
• The Micro MRI is at the 26th percentile and in the upleg of its cycle. As mentioned above, the most likely path indicated by the projections is for it to move higher through early November and then begin another downleg that will be in place since through the end of the year.

Valuations for the DJIA are Still High

Stepping outside the MRI framework, the valuations of the companies in the DJIA are still high compared to their valuations between January 2000 and last Friday. Figure 1 below shows the current ratios and historical reference points. Please see this page for a brief description of these ratios.

Figure 1

The Price/Book (P/B) and Price/Sales (P/S) ratios are most important for this discussion. They are still high compared to the range of values since January 2000. The percentile rankings of the current values are 85th and 87th, respectively. In a time of slower economic growth and higher interest rates, I expect these valuation ratios to drop to levels close to or below their average valuation ratios indicated above (their 50th percentile rankings). DJIA prices will need to fall further to achieve those levels. In my elaboration of the industry adage “A Bull Market Climbs a Wall of Worry,” point #3 is relevant here – the current high valuation ratios suggest that stock prices will fall more than they already have.

This relatively low P/E ratio is noteworthy. When P/B and P/S ratios are high and the P/E ratio is relatively low, we can infer that the market, in its collective wisdom, is indicating that the current level of corporate earnings is abnormally high and is likely to decline. 

Figure 2 below shows the price of the DJIA (log scale, brown line), with the Peak-Earnings Indicator (PEI) in yellow. Last Friday is at the far right. The current decline, which began in December of 2021, is indicated by “D”. As you can see the PEI is still high compared to the PEI before the Global Financial Crisis (A) and the Covid Crash of 2020 (C).

Figure 2


The double blue line in Figure 2 above indicates actual earnings of the DJIA companies. At the far right of the line, we can see that earnings level has declined from its peaks at the end of 2021. But we can also see that the decline in earnings has been less than the declines that occurred after the high PEI readings at points A and C, despite the indicator being at a similarly high level. 

The recent decline in earnings thus far is even less than decline taking place after B, even though the PEI is currently quite a bit higher now (D) compared to B. If historical patterns hold true, corporate earnings are likely to continue to decline further from here. If you would like to read my discussion of the PEI, I describe it here.

Thus, with the Macro MRI indicating a lack of resilience, high P/B and P/S valuation ratios, and the PEI still signaling abnormally high earnings and lower future earnings, the most likely path for stocks as tracked by the DJIA is for further stock price declines than we have seen thus far in 2022. Other stock indexes have similar MRI conditions, with the exception of the tech-heavy NASDAQ, which is a little further along the downleg of its Macro cycle. It is perhaps closer to the inevitable inflection point indicating the end of its bear market.

Bonds Likely to Become More Attractive

As the country moves into an economic recession, the Fed will be more inclined to slow interest rate increases and perhaps even induce lower rates. These moves may make our bond ETFs more resilient. I suspect that decreasing our Box #2 Cash levels and increasing the bond allocations will be one of next major moves. However, as of today, the timing is not right for this change.

2. New Page – Repeated from Last Week’s Note

On page 2 of the weekly report, I show the target weights for all model portfolios. There is no new information on page 2. This page simply pulls together information stated on other pages, which still exist. My goal is to simplify your task of locating the target weights you need to use.

If you have selected the portfolio indicated as “Main” as your long-term portfolio, the orange box indicates the portfolio that you should be using at this time. The portfolio in the orange box is one step less aggressive than the Main portfolio, as specified in the note, “Box #3 Portfolio Shift Relative to Your Long-term Portfolio: -1.”

If you are using for your long-term portfolio one other than the Main portfolio, use the next less aggressive portfolio to implement the Box #3 Portfolio Shift: -1.

3. Performance (not audited)

Below are estimates of the returns that one would get from December 31, 2021 through last Friday by following the instructions 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 10/21/2022 are:

   Diamond:    -8.6%

   Sapphire:    -10.7%

These returns compare favorably to the following alternatives:

   DJIA:         -13.4%
   S&P500:     -20.3%
   NASDAQ:    -30.1%
   IEF:            -18.0% ETF for the US 7-10-year Treasury bond index, with no leverage

   VBINX:     -19.5% Vanguard Fund with 60% of assets in stocks and 40% in bonds
   VASGX:    -21.5% Vanguard Fund with 80% of assets in stocks and 20% in bonds

Endnote: Main Portfolios

The main portfolio in the Diamond publication is sg235, and 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 figures 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 (4 pm, Eastern) 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 aggressive 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.

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

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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.

Weekly Note - June 22, 2022

 The MRI suggest the end of the current stock price decline is several weeks away.

This post describes the current level of the DJIA from two perspectives. First, I compare this decline to other major price declines over the last 100+ years. If these past declines are a relevant guide, the depth of the current decline is as severe as the others considered. 

Second, the DJIA’s current valuation measures (Price/Book and Price/Sales) compared to the period from 1993 to the present suggests that prices need to fall further to approach low valuation levels that have been attractive historically. From this perspective as well, the current decline appears to be several weeks away from the end. 

For the last 20+ years, the Fed has stepped in to support economic growth by lowering interest rates when the stock market weakens and the economy begins to falter. However, the Fed is far less likely to lower interest rates in this situation because doing so would, at this time, encourage inflation and fighting inflation is currently the Fed’s primary objective. The MRI don’t tell us if the economy will slip into recession. They indicate market resilience and vulnerability. At this time, the stock market looks very vulnerable to declines. 

The Current Stock Market Decline Compared with Others Over the Past 100+ Years

As of last Friday, we are at week 24 since prices peaked in early January of this year. Compared to major declines over the last 100+ years, the current decline is more severe than prior declines, many of which went on to experience even deeper declines before moving higher. 

Earlier this year, I wrote that 2022 may be similar to the DJIA decline that began in 2000. The collapse of the Dotcom bubble beginning in 2000 most directly affected the NASDAQ stock index, which is biased toward tech stocks. But the collapse also affected the DJIA. The DJIA made a long slow decline from 2000 to 2002 and then dropped again in 2003. During that period the Onyx sleeve consisting of the ETFs XLP (consumer staples stocks), XLU (utilities stocks), and UST (7-10-year Treasury Bonds), and SHY (1-3-year Treasury bonds) performed well.

However, over the last few months, we have seen stronger-than-expected declines in the Onyx sleeve ETFs. Thus, the decline that began in 2000 is not a useful guide for this decline. The broad nature of this decline suggests it could continue for several weeks more. 

Figure One below shows price performance of the DJIA for several declines since 1929, including those beginning after prices peaked on:

• 1.       9/6/1929
• 2.       5/3/1937
• 3.       11/3/1939
• 4.       1/5/1973
• 5.       5/29/1981
• 6.       1/21/2000
• 7.       10/12/2007
• 8.       2/14/2020
• 9.       1/7/2022 - the current decline

The horizontal axis is the number of weeks after the DJIA peaked. The line descends to the lowest point in that decline and is then horizonal from that point until it reaches the scale on the right. All lines start with the value of 1.0. A decline ending at 0.60 on the scale, for example, means a 40% loss of the starting value. The thick green line is the current decline.

Figure One – Nine Major Price Declines Since Early 1929

The line shown by “A” is the decline beginning in 1929. The DJIA declined over a period of 148 weeks, to 7/1/1932, to a value of about 0.13, or 13% of its original value (scale on the right), which means that the DJIA lost about 87% of its value during that decline, definitely a startling loss. 

The line by “B” is the decline that began after the peak in prices on 2/14/2020 and relates to the COVID crash. This decline was even steeper than the early weeks of the 1929 decline. The DJIA took only five weeks to reach the bottom of the 2020 decline. It declined to 65% (scale on right) of the value it had on 2/14/2020, representing a loss of 35%. 

Figure One presents a reasonable comparison for the current decline (shown with the thick green line) showing the depth and duration of major declines since early 1929. Against this backdrop, the current decline has a relatively short duration, which is consistent with the MRI conditions indicating that the bottom of the market is several weeks away. When the bottom of the market does arrive, the DJIA will likely be at a lower level than it is now. 

Excluding the decline starting in 1929, all other declines ended at values between roughly 0.45 and 0.80, representing losses of about 20% to 55%. The current decline for the DJIA, shown by the heavy green line, is just approaching that range with a roughly 17% decline so far. 

For clarity, Figure Two below is the same as Figure One but without the declines beginning in 1929 and 2020. The depth and duration of the 1929 decline should be kept in the back of our minds but we are not likely to have a decline of its scale in the near-term. Policy makers made several mistakes during the 1929 decline, which I referenced in an earlier note. 

The 2020 decline is not applicable to the current decline because it was ended by extraordinary stimulus around the world. Stimulus of that scale seems less likely to occur for this decline because there is recognition that the stimulus implemented to address the 2020 decline may have magnified the inflation challenge we now face, and the Fed has indicated that it will aggressively fight inflation by increasing rates and reducing other measures supportive of the markets. See endnote #1.

Figure Two – Major Declines Excluding 1929 and 2020

The heavy green line in Figure Two (and Figure One) represents the current decline, after prices peaked 1/7/2022. As of last Friday (6/17/2022), we were at week 24 and the DJIA is at 0.83 of its beginning level, which means a 17% loss.  The other declines shown in Figure Two had an average loss of 9% by week 24.  Thus, the current decline is comparatively steep. 

The orange line by “C” is shows the path of the decline that began in 2000, after the Dotcom bubble. Especially over the last few weeks, the market has experienced sharper losses than the 2000 decline. It is no longer reasonable to compare the current decline to the 2000 decline. 

Of the declines shown, the average total decline was 39%, and this may be a reference point to consider for the magnitude of decline that may transpire for the current decline. This is not a forecast, but simply an observation to help frame expectations. 

Valuations Suggest that Prices are Not Yet Low

Figure Three below shows the price of the DJIA (brown, log scale, right) since 1993, along with the Price/Book (purple) and Price/Sales (blue) ratios. Valuation data for earlier dates is not available through my data sources. The current readings are at the far right of the figure. 

All else equal, lower valuation ratios are more attractive for purchasing stocks. After a period of price declines on investor concerns about the future, unusually low valuation ratios entice investors to buy even when the future is questionable. We can see from prior declines the valuation ratios that enticed investors to buy.

The ellipses show the levels of these ratios at the bottom of the major declines of the period from 1993 to the present. In all cases, the current ratios are higher than the levels at the ends of prior declines, suggesting that the current ratios may need to decline further to attract investors. The current level of the Price/Book ratio (purple, left scale) is 4.0. This means that the current price of all companies in the DJIA is four times the sales of all those companies. The average Price/Book value for this entire period is 3.3. The value of this ratio at the bottoms of the prior declines indicated is 3.0 or lower. Thus, the current value is still high by these historical standards. 

The Price/Sales ratio (blue, also on left scale) is currently 2.1, meaning that the price of the DJIA companies is just over twice the sales of those companies. The average Price/Sales value for this entire period is 1.4. For the end of the 2000 decline in 2022, the Price/Sales ratio was about 1.0.  In 2009, it was 0.6. In 2020, the lowest value was 1.4. Thus, the current value is still high by these historical standards. 

The high valuation ratios of the last few years have been more acceptable to investors because interest rates have been low. Low interest rates tend to boost economic growth, and high economic growth justifies high valuation ratios, all else equal. Low interest rates also give the long-term future growth of book value and sales a greater weight in determining the current fair value of a company. But when interest rates move rapidly higher, strong future economic growth is called into question and any growth that does occur in the distant future has less weight in determining current fair price of stocks.  Thus, a sharp move higher in interest rates has these two important effects. 

These forces can cause investors to care much more about the near-term prospects of a company.  Companies with weak near-term earnings but promises of high future growth can be shunned by investors because the rosy future may not materialize as expected. Therefore, indexes that are heavily weighted to companies promising high future growth, like the NASDAQ stock index, can become relatively more vulnerable to price declines. We are seeing this in the performance numbers reported below – the NASDAQ has had greater losses this year than the DJIA. 

While the above material describes the context of the current market, our portfolios are influenced more by the MRI. The MRI indicate that the stock market will continue to be vulnerable to declines for several more weeks. 

Performance

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 #2 for a brief comment on the main portfolios. Contact me with questions. 

The year-to-date returns as of 6/17/2022 are:

   Diamond:    -6.3%
   Sapphire:   -8.5%

These returns compare favorably to the following alternatives:
   DJIA:       -16.9%
   S&P500:     -22.3%
   NASDAQ:     -30.7%
   IEF:        -12.4%   ETF for the US 7-10-year Treasury bond index, with no leverage

   VBINX:      -18.9%   Vanguard Fund with 60% of assets in stocks and 40% in bonds
   VASGX:      -19.8%   Vanguard Fund with 80% of assets in stocks and 20% in bonds

end

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Endnotes

1 - Well before COVID, we had an extended period of exceptionally low interest rates.  During that period, policy makers around the world tried to get inflation to move higher. The Fed wanted to get inflation up to 2% and was struggling to induce inflation by keeping interest rates exceptionally low. During this period, the prices of many assets went higher. Stocks, bonds, real estate, cryptocurrencies, etc. rose in price. Then COVID came along, and the government added even more stimulus to keep the economy from falling further than it otherwise would. 

Inflation has gone higher – much higher - than policy makers expected.  In response, the government support is being retracted.  Most notably, the Fed is pushing interest rates higher. As rates go higher, all the assets that seemed reasonably priced two years ago are seeming more expensive. Stocks, bonds, real estate, cryptocurrencies, etc. are now moving lower. 

The MRI started to indicate greater market vulnerability in the middle of 2021. From this perspective, a good portion of what we are experiencing was already in motion at that time. The war in Ukraine and the resulting boost in energy prices has added to inflationary pressures but does not appear to be the sole cause of the inflation we are experiencing. The MRI indicate that forces over many years contribute to the current conditions. From this perspective, addressing the weaknesses in the stock market and probably the economy will be a long-term effort. This further supports the view emanating from the MRI that we have several weeks to go before the decline ends. 

2 - 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. 

Weekly Note - May 11, 2022

As mentioned in last week’s note, the market is primed for a return reversal in response to the declines of the prior several weeks.  In this type of return reversal, stock prices stabilize or move higher for a few weeks.  In addition, we may see the Micro MRI shift to the upleg of its cycle at the end of May or early June.  The Micro MRI for the DJIA was last Friday at the 46^th percentile of levels since 1919 and moving lower.  Based on its level being close to the midpoint of its range, it may take a few weeks to reach the lower end of the downleg in the Micro MRI.

But these positive signs for the stock market themselves do not indicate the bottom of the stock market. Historically, the bottom of the stock market is best indicated by the Macro MRI shifting to the upleg of its cycle and/or Exceptional Macro MRI appearing. 

Please see this link for a discussion of the language I use for the MRI: https://focused15investing.com/language.   

You may remember from an earlier note my elaboration of an investment industry adage, “a bull market climbs a wall of worry.” I’d like to give a status report on the current condition of the US stock market that begins with a well-known industry saying, a bull market climbs a wall of worry. 

A Bull Market Climbs a Wall of Worry

1.      A bull market climbs a wall of worry - This means that during a bull market (when stock prices move higher for long periods), the path to higher stock prices is a slow climb and is never free from worry about company growth, stock valuations, the US dollar, trade wars, wars, politics, etc. If one were to wait until the market is worry-free, one would miss the bull market.  The Macro MRI, which indicates the long-term trend, peaked in December 2021 at the 78^th percentile of its levels since 1919.  In the MRI framework, this peak marked the end of the bull market. 

2.       After climbing the wall of worry, the bear market jumps out the window - This means that once a bear market begins, the market moves down quickly and without regard for the specifics of the situation. Historical data validate this; bull markets (slowly climbing the wall of worry) tend to last much longer than bear markets.  For this reason, many say to just stay invested in the markets for the long term because the markets go up most of the time, even if the stock market drops 20, 40, 60% or more in a bear market.  Yet, by avoiding the steep losses, we can achieve better mid- and long-term performance. 

Since the beginning of January 2022, the DJIA has declined in price and the Macro MRI has continued in been in the downleg of its cycle.  As of last Friday (May 6), the Macro MRI was at the 67^th percentile.  It would not be unusual for the downleg to end at a level at or below the 40^th percentile.  From this perspective, it currently appears that this period of low resilience will last a few more months. 

I have mentioned in prior notes that I expect the short-term price swings to be muted because the forecasts of the Micro MRI have called for cycles of smaller than usual amplitude. This means that stock prices will not fall as abruptly as they do in typical bear markets. This observation is based on my recent research on the drivers of resilience. I identified when the drivers are biased toward abrupt daily price declines, and when they are biased toward gradual daily price declines. 

Of the twenty largest daily price declines since 1900, three of them took place before the historical period I cover, which begins in 1919.  Of the remaining seventeen, thirteen (76%) of the largest declines took place when one would objectively, using the finding of the recent research, expect abrupt declines.  This includes all the major declines etched in our minds, 1987, 2020 (Covid), 1929 (beginning of Great Depression), 2008 (Global Financial Crisis), and 2000 (the end of the Dot.com) bubble.   

Three of the remaining four occurred when the market conditions shifted to being biased to gradual declines but were follow-on declines from a bear market that began in a period biased toward abrupt declines.  Two of these large daily declines occurred in 1932, which was a continuation of the abrupt declines that began in 1929.  One was in 2001, which was a continuation of the abrupt declines that began in 2000.

Only one of the seventeen largest daily declines occurred during a period expected to have gradual price declines.  This is loss in late 1997 related to the Asian debt crisis.  

These patterns of the last 100 years have held true for the last four months; we have been in a period biased toward gradual price declines. 

3.     Valuation tells you what floor the market is on when it jumps into a bear market - A high stock valuation means the market is on a high floor and has farther to fall.  A good valuation measure for our work is the price-to-sales for the DJIA, which is shown for the period 1997 through today.  Price-to-sales is shown by the blue line.  The DJIA price is in black. 

 

The current price-to-sales ratio of 2.24 for the DJIA indicates that the current price of the DJIA is 2.2 times the reported sales of the roughly 30 companies in the DJIA.  This is higher than the average level of 1.6 over the time period shown.  In general, a high ratio can be justified if sales are widely expected to grow dramatically in the future.  But if expectations for future sales growth begin to be viewed as unrealistic, prices decline.  This type of euphoria about future sales growth took place in the late 1990s and we can see the ratio increase before 2000.  But in roughly 2000, investors came to see these lofty expectations as unrealistic. The price of the DJIA did not move higher over the next few years while sales increased driving the price-to-sales ratio lower.  The DJIA price did not move high until after the valuation measure declined to about 1.0 in 2003.    

While the price-to-sales ratio has decreased since its peak in May of 2021, it is still at a very high level, and higher than any level prior to the Fall of 2020.  For this ratio to go down, sales need to increase or stock prices need to fall.  Increasing sales may be difficult at this time.  Supply chain woes limit production, inflation eats away at consumer’s purchasing powers, and higher interest rates siphons money into debt financing and away from other expenditures. 

It is important to note that low interest rates can allow valuation ratios to be higher than they would be otherwise, which makes comparing valuation ratios from different interest rate environments less reliable.  Since we have had low interest rates for the last few years it may not be appropriate to compare them to ratios of the late 1990s when interest rates were higher.

But we can look at how much the ratios declined during the markets characterized by a steeply declining Macro MRI.  The valuation levels of notable market tops and bottoms suggest that the current price for the DJIA (i.e., 2.2) is still high.  

2000 top: 2.0                      2003 bottom: 1.0              Decline of 50%

2007 top: 1.4                      2009 bottom: 0.7              Decline of 50%

2018 top: 2.2                      2020 bottom: 1.4              Decline of 36%

2021 top: 2.7                      Current: 2.2                      Decline of 19%

In the earlier declines, the bottoms of the market had price-to-sales ratio declines of 36-50%.  The current level represents a decline of 19%. 

This valuation perspective suggests the DJIA has not reached the bottom.  This is consistent with the status of the Macro MRI discussed above.  

4.     The cycles also tell us when the market is ready to become a bull market and begin to climb the next wall of worry - Consistent with the image of the wall of worry, we should expect the next bull market to begin while there is still bad news in the marketplace.  We should not wait for all the bad news to go away before becoming more aggressive.  However, we need to focus on the MRI (Macro, Exceptional Macro, and Micro) so we can avoid being distracted by bad or good news or prices moving higher because of a return reversal or a shift in to the upleg of the Micro MRI.    

There are two ways the Macro MRI ends its downleg and moves higher in a way that signals the beginning of a bull market and that makes it prudent to be more aggressive.  The most common over the last 100+ years is for the Exceptional Macro to appear, which signals exceptionally high resilience and foreshadows a later shift in the Macro MRI to the upleg of its cycle. The Exceptional Macro is not close to appearing at this time.   

The less common way is for the Macro MRI to turn positive without the appearance of the Exceptional Macro, which happened in 1927 and 1993. The computer models watch for this type of shift each week and I also review the drivers of the Macro MRI to develop the near-term outlook.  The drivers of the Macro MRI currently suggest that the greater resilience may develop in early July, as mentioned last week.

I mention these details as a reminder that we should not be complacent about the lack of major declines in the DJIA and conclude that the bottom of the market is just around the corner.  We could slip into a period biased toward more abrupt price declines before the Macro MRI ends its downleg.

The market may start to move more dramatically over the next several weeks and we will probably trade more frequently to position our portfolios for the next phase of the markets. 

Performance

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 the endnote for a brief comment on the main portfolios.  Contact me with questions. 

The year-to-date returns as of 5/6/2022 are:

  Diamond:           -3.0%

  Sapphire:           -5.0%

These returns compare favorably to the following alternatives:

  DJIA:                     -8.9%

  S&P500:             -13.1%

  NASDAQ:           -22.2%

  IEF:                     -11.7%   ETF for the US 7-10-year Treasury bond index, with no leverage

 

  VBINX:               -12.9%   a Vanguard Fund that has 60% of its assets in stocks and 40% in bonds

  VASGX:              -13.5%   a Vanguard Fund that has 80% of its assets in stocks and 20% in bonds

 

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Note – 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 adjusting Box #3) 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.