Weekly Note - February 21, 2024

 Please see this page for descriptions of the language used to discuss the MRI:

      https://focused15investing.com/language

This note discuses a) current market conditions, b) why there is historical precedent for high stock valuations we are experiencing, and c) an article about pessimistic views of the markets. Sections a and b have been revised for clarity and updated to reflect current statistics (highlighted in yellow).  Section c is new this week.  

A. Current Market Conditions 

The positive long-term trend of the stock market continues. The Macro MRI is in the upleg of its cycle, moving to the 39.1th percentile of levels since 1918 as of last week, up from the 38.6th percentile the prior week. This is a relatively low level and suggests that the positive long-term trend of the DJIA can continue for some time. This marks 8+ weeks of consistent movement higher – a level of consistency that did not exist last year.

The Exceptional Macro is also present. Last year, this very important indicator shifted erratically between being present and not, a pattern that has rarely occurred over the last 100+ years. It has been consistently present for the last several weeks.

The Micro MRI, which tracks the short cycles of market resilience, has been in the downleg of its cycle the last several weeks. As of last week, it was at the 37th percentile of levels since 1918, making a rapid drop from the 81st percentile three weeks prior. A ten-point drop per week is a typical pace. Over this same period, DJIA stock prices have not experienced dramatic and have even moved higher, which is the expected behavior only when the Exceptional Macro MRI is present (as it is now). Thus, the market action of the last month has been consistent with normal market behavior from the perspective of the MRI.

If the Micro MRI downleg continues at its recent pace, it will reach a low level in its historical range, say, the 20th percentile, in the next few weeks. It will then soon shift to the upleg of its cycle. At that time, we are likely to have all three of the MRI indicating market resilience. If the conditions do indeed evolve in this way, the DJIA may then mover higher more quickly.

As I have discussed with many users over the last few weeks, we were more defensive in January than the algorithms have called for. We wanted to confirm that there is indeed greater stability in the Macro and Exceptional Macro MRI considering the high current stock market valuation levels. We have seen a sufficient level of stability and, as the section below describes, high valuation levels appear to be common in similar historical periods. Thus, our portfolios are becoming more aggressive. If these trends and conditions continue, we will hold less Box #2 Cash and have higher target weights in the DJIA- and NASDAQ-linked ETFs toward the end of February or in early March.

B. Historical Precedents for High Stock Valuations Ratios 

A remaining concern from the 2022/23 period has been high stock valuations. The stock price declines of 2022/23 were not deep enough for important valuation metrics such as Price-to-Earnings and Price-to-Book ratios to decline meaningfully. Valuation ratios have remained stubbornly well above their average levels since 1997, the earliest year for which we have data for the DJIA’s valuation metrics.

Over the last several months, we have evaluated cycles of market resilience that are much longer than the multi-year cycle of the Macro MRI. These might be called “Mega cycles” and are clearly identified by our recently-developed drivers of risk tolerance. Mega cycles began in 1942, 1958, 1970, 1982, 1997, 2009, and 2022 (the current one).

We evaluated the Price-to-Earnings ratio for the S&P500 stock index (which has more Price-to-Earnings ratio history than does the DJIA) compared to various segments of the Mega cycle. Over the first roughly 4 years of the Mega cycle, the Price-to-Earnings ratio of the S&P was significantly higher than it was in other portions of the Mega cycle. This suggests that investors are inherently more optimistic during the first segment of the Mega cycle. During the first four years, the Price-to-Earnings ratio of the S&P 500 starts high, moves higher as prices move higher, and then drops as higher corporate earnings occur.

This pattern would explain why high valuation levels have persisted. If the historical pattern continues, high valuation levels could remain elevated for several more quarters. This implies that high valuation levels alone may not produce a drop in DJIA prices.

The most recent Mega cycle began in 2009. It was preceded by a 53% decline in the DJIA. The DJIA did not experience a drop of that magnitude prior to the beginning of this cycle. The most recent similar Mega cycle began in 1997. It took two-and-a-half years for prices to peak after the beginning of that cycle. If that cycle is relevant to this one, it is likely to be a few quarters before prices peak. There was a great deal of anxiety about high valuations in the late 1990s, just as there is now.

The MRI are currently moving in a manner consistent with this longer-term outlook. If the MRI diverge from this outlook, we will follow the MRI.

The impact of this research is that we will be more tolerant of high valuation ratios in determining Box #2 Cash levels and the ETFs included in the portfolios.

C. Pessimistic Views

I am aware of the concerns voiced by well-respected investment professionals described in this article: 

    https://markets.businessinsider.com/news/stocks/stock-market-outlook-recession-economy-warnings-grantham-gundlach-rosenberg-shilling-2024-2. 

I believe the views have merit and I feel similar emotions. However, market conditions are not currently right for a major decline. Current conditions are most consistent with a market weakness through the first week of March, followed by greater market resilience. Current market behavior is consistent with this view.  

Should conditions change and indicate greater market vulnerability, we will trade outside of the regular trading schedule.  

Weekly Note - February 14, 2024

Please see this page for descriptions of the language used to discuss the MRI:
      https://focused15investing.com/language

This note discuses a) current market conditions and b) why there is historical precedent for high stock valuations we are experiencing. Both sections are updated versions of last week's note.

Current Market Conditions 

The positive long-term trend of the stock market continues. The Macro MRI is in the upleg of its cycle, moving to the 38.6th percentile of levels since 1918 as of last week. This is a relatively low level and suggests that the positive long-term trend of the DJIA can continue for some time. This marks 8+ weeks of consistent movement higher – a level of consistency that did not exist last year.

The Exceptional Macro is also present. Last year, this very important indicator shifted erratically between being present and not, a pattern that has rarely occurred over the last 100+ years. It has been consistently present for the last several weeks.

The Micro MRI, which tracks the short cycles of market resilience, has been in the downleg of its cycle the last several weeks. As of last week, it was at the 50th percentile of levels since 1918, making a rapid drop from the 81st percentile two weeks prior. A ten-point drop per week is a more typical pace. Over this same period, stock prices have moved higher, which is the expected behavior only when the Exceptional Macro MRI is present (as it is now). Thus, the market action of the last month has been consistent with normal market behavior from the perspective of the MRI.

If the Micro MRI downleg continues at its recent pace, it will reach a low level in its historical range, say, the 20th percentile, in the next few weeks. It will then soon shift to the upleg of its cycle. At that time, we are likely to have all three of the MRI indicating market resilience. If the conditions do indeed evolve in this way, the DJIA may then mover higher more quickly.

As I have discussed with many users over the last few weeks, we were more defensive in January than the algorithms have called for. We wanted to confirm that there is indeed greater stability in the Macro and Exceptional Macro MRI considering the high current stock market valuation levels. We have seen a sufficient level of stability and, as the section below describes, high valuation levels appear to be common in similar historical periods. Thus, our portfolios are becoming more aggressive. If these trends and conditions continue, we will hold less Box #2 Cash and have higher target weights in the DJIA- and NASDAQ-linked ETFs toward the end of February or in early March.

Historical Precedents for High Stock Valuations Ratios 

A remaining concern from the 2022/23 period has been high stock valuations. The stock price declines of 2022/23 were not deep enough for important valuation metrics such as Price-to-Earnings and Price-to-Book ratios to decline meaningfully. Valuation ratios have remained stubbornly well above their average levels since 1997, the earliest year for which we have data for the DJIA’s valuation metrics.

Over the last several months, we have evaluated cycles of market resilience that are much longer than the multi-year cycle of the Macro MRI. These might be called “Mega cycles” and are clearly identified by our recently-developed drivers of risk tolerance. Mega cycles began in 1942, 1958, 1970, 1982, 1997, 2009, and 2022 (the current one).

We evaluated the Price-to-Earnings ratio for the S&P500 stock index (which has more Price-to-Earnings ratio history than does the DJIA) compared to various segments of the Mega cycle. Over the first roughly 4 years of the Mega cycle, the Price-to-Earnings ratio of the S&P was significantly higher than it was in other portions of the Mega cycle. This suggests that investors are inherently more optimistic during the first segment of the Mega cycle. During the first four years, the Price-to-Earnings ratio of the S&P 500 starts high, moves higher as prices move higher, and then drops as higher corporate earnings occur.

This pattern would explain why high valuation levels have persisted. If the historical pattern continues, high valuation levels could remain elevated for several more quarters. This implies that high valuation levels alone may not produce a drop in DJIA prices.

The most recent Mega cycle began in 2009. It was preceded by a 53% decline in the DJIA. The DJIA did not experience a drop of that magnitude prior to the beginning of this cycle. The most recent similar Mega cycle began in 1997. It took two-and-a-half years for prices to peak after the beginning of that cycle. If that cycle is relevant to this one, it is likely to be a few quarters before prices peak. There was a great deal of anxiety about high valuations in the late 1990s, just as there is now.

The MRI are currently moving in a manner consistent with this longer-term outlook. If the MRI diverge from this outlook, we will follow the MRI.

The impact of this research is that we will be more tolerant of high valuation ratios in determining Box #2 Cash levels and the ETFs included in the portfolios.

Why Bond Prices Drop as Rates Rise

Overview

• The following scenarios show that the impact of interest rate changes on your portfolio depends on whether you are holding a bond to maturity or selling it before it matures. 
• Standard investment industry practice is to estimate the value of investment holdings as if they were sold on a given day at the prices of that day. This practice is called “marked-to-market.” Most bond funds and ETFs are marked to market each day.
• However, if you buy and hold an individual bond to maturity (when the bond issuer pays you the face value of the bond) all the marked-to-market periods before that maturity date are irrelevant. When the bond matures, you will likely get from the bond issuer the amount promised. 
• But if you decide to sell the bond before it matures, the prevailing interest rate that bond buyers are expecting affects the price you will obtain when you sell the bond. 
• The following slides show these two scenarios.

Scenario A – Buy and Hold to Maturity

Assuming the issuer of the bond, for example the US government, does not default/go out of business, you will get the interest payments and bond repayment as promised, as shown in Figure 1. Any change in interest rate over the holding period is irrelevant to you. 

Figure 1 - Buy and Hold to Maturity, No Inflation

If we assume that inflation is 5% per year (coincidentally the same as the bond’s coupon rate) over the holding period, we can see that the “present value” of all proceeds from owning the bond protected the value of your money from the impact of inflation. Figure 2 below shows this result of this discounting process and the value of the yearly coupon payment in the dollars of year 0.  The bond protected you from inflation and did this without a high probability of losing money because of the trustworthiness of the bond issuer. 

Figure 2 - Buy Bond and Hold to Maturity, Inflation is 5%

Scenario B – Selling Bond Before It Matures

For scenario B, assume a) you want to sell the bond at the end of year 2, and b) the prevailing interest rate environment has changed, with bonds maturing in three years being sold with a 10% interest rate. As the seller of the bond, you will need to compete with the other bond sellers offering a 10% interest rate.  To do that, you will need to accept a lower price for your bond of about $87.57, shown in Figure 3 below. 

Figure 3

Figure 4 below is the same as Figure 3 but with the addition of arrows showing that the market value at the end of year 2 is $87.57, which is the sum of the present values of a) the remaining three interest payments ($5 each), and return of the original bond (face value of $100) value discounted at 10% rate. The higher prevailing interest rate means that the present value of those payments over the next three years is lower compared to if rates had remained at 5%

Figure 4

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Weekly Note - October 25, 2023

This note covers:

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

The stock market has the following conditions:

  Negative for stock prices -

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

   Positive for stock prices -

• The potential for a counter-trend rally in stock prices (this condition is causing our algorithms to continue to hold the DJIA- and NASDAQ-linked ETFs). While this is a positive dynamic, it is short-term in nature.

Since the only positive current dynamic is transitory and is not likely to last as long as the negative dynamics, it is prudent to continue to reduce risk in our portfolios by raising Box #2 Cash in advance of what the algorithms indicate. 

Discussion

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

You may recall from prior notes that the positive long-term trend in stock prices since last September has been weak by historical standards:

• The Macro MRI, which indicates the long-term trend of stock prices, has moved almost horizontally for about a year. It is more common for it to move more steeply up or down.
• The Exceptional Macro, which appears when the Macro MRI is likely to develop a more positive slope, has been off and on over the same period. It typically changes status more decisively.

Thus, the price recovery over the last year has been abnormally weak making the recent shift to a more negative trend unsurprising. We are now in a period in which the long-term trend of prices is negative, which is a bear market using our definition.

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

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

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

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

    Risk Tolerance Drivers

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

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

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

The current risk tolerance forecasts are:

• Short-term risk tolerance was forecast to begin decreasing from the end of September (a few weeks ago) through mid December. We have already seen this shift in recent stock price declines. 
• Long-term risk tolerance is likely to decrease more sharply beginning the end of November.

As discussed in a later section, the stock market is under a relatively heavy economic load because valuations and interest rates are high. These conditions likely constitute an economic need for lower stock prices. We expect the market to continue to respond to shifts in collective investor risk tolerance over the next few months.  

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

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

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

    High Economic Load on the Stock Market

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

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

Figure 1 

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

    The Positives for the Stock Market

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

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

Figure 2

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

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

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

Other Portfolio Holdings

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

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

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

End

Weekly Note - September 6, 2023

The figures below compare the current stock market environment to three prior periods through the lens of the MRI. They show that the mild recovery of the DJIA since the price of the DJIA hit its low level about a year ago (September 23, 2022) has been comparatively weak. The weakness of the current period explains why our most aggressive ETFs – the DJIA- and NASDAQ-linked ETFs – have lower weights starting this week.

Our portfolios are likely to remain defensive for a few weeks. The specific element of the algorithms causing this change relates to the market being at a possible transition in its long-term trend – moving from a mildly positive trend to a more negative trend. In addition, I expect resilience to decrease as we move through the end of year, based on the drivers of resilience we have identified over the last few years. We could see more resilience during September, as mentioned in prior notes, but the dynamics described below are, according to the algorithms, taking on greater importance.  

Thus, the defensive shift in the target weights driven by the algorithms is not unexpected and it is even welcome. It is why I have indicated to those currently intending to move money into investment accounts to move money in gradually over time. Thus, I am currently cautious about the stock market even if the economy is strong and inflation has declined meaningfully over the last year.

Figure 1 below shows the price of the DJIA (on a log scale) centered around the low price it experienced on September 23, 2022, which was roughly a year ago. It is difficult to draw conclusions from the one line on Figure 1 but I show it to clearly identify the current period; the line is red.

Figure 1


Figure 2 shows three other market declines that have similar characteristics in terms of when they take place in broader market cycles. The purple line shows the period with a low trough in 1958, the blue shows 1970, and the green shows 1982. The lowest price of these periods is aligned to the low point of the current period, at week number 520 (roughly a year ago).

Figure 2


The current period’s rebound from the low price last September has been less dramatic than the others shown. The same message is seen by looking at just the Macro MRI for the different periods, shown in Figure 3.

Figure 3


The Macro MRI normalizes the index’s price movement and shows the trend more clearly. We can see in Figure 3 that the inflection point at the time of the lowest price (September 23, 2022 for the current period) is not as pronounced as it was for the other periods. The macro MRI has been slower to move the upleg of its cycle and its current slope is shallower than the others. These characteristics underscore the tentative nature of the price recovery for the DJIA.  

Periods like the others listed make the best Plant seasons and a good time to switch to a more aggressive model portfolio. Unfortunately, the current period did not have a strong inflection point last September.

We can see the weakness of this recovery in how the Exceptional Macro has behaved since the low in September of last year. Figure 4 shows the Macro and Exceptional Macro for same four periods. As you may recall, the Exceptional Macro is designed to be an alert for when a strong upleg in the market is likely to take place.

Figure 4


You can see in Figure 4 that for the other three periods, the Exceptional Macro appeared and (after a false signal for 1983 in green and 1970 in blue) remained present for many weeks (roughly a year). During the current period, the Exceptional Macro has appeared intermittently. This can be more clearly seen in Figure 5.

Figure 5


Although difficult to see in Figure 5, the Exceptional Macro ended in the last two weeks. This is usually a negative for stock prices. The algorithms have responded to this and other indicators of weakness and reduced the target weights of DJIA-linked ETFs.

Since the beginning of the year, the main algorithms that determine the weight of the DJIA-linked ETFs have navigated this situation reasonably well; they have produced positive returns. But the strength of the DJIA recovery has not been sufficient to justify to switch to a more aggressive portfolio as would have been the case in the other periods shown above.

The weekly publications are designed to allow us to switch easily to more aggressive portfolios when the market begins the upleg of its cycle in a more definitive way. The timing of the switch is a subjective call on my part and is heavily influenced by the information presented above. Over the last year, the recovery has not been as strong as is typically the case.

Because it has not been prudent to switch to a more aggressive portfolio, the portfolio we use has been moderately defensive and therefore has a higher allocation to traditionally more defensive ETFs such as XLP (consumer staples companies), XLU (utilities) and those linked to the US 10year bond index (ETFs UST and TYD). However, the utilities and 10-year bond ETFs have been hit hard by rising inflation and have hurt portfolio performance.

Should the market decline more abruptly over the next few months, the defensive ETFs may be useful. The Fed may lower interest rates as the markets and economy soften and our defensive stock ETFs (XLU, XLP) and the 10-year bond ETFs (UST, TYD) will be supported by that shift. Thus, the composition of our current portfolios is reasonable. Should the stock market enter a stronger, more resilient phase we will switch to a more aggressive portfolio. I do have waiting in the wings a set of portfolios that will be effective in a robust market recovery accompanied by persistently high interest rates (they hold minimal weights in the defensive ETFs) and will introduce them later if needed.

Weekly Note - June 14, 2023

Sections in this post:

A. Confusing Time
B. This Type of Divergence is Expected and Why We Focus on the DJIA
C. The Spread Between Leading and Lagging Sectors is High
D. Not Yet a Bull Market for the DJIA
E. High Stock Valuations
F. Corporate Earnings Have Not Yet Declined
G. A Period of Low Investor Excitability Has Just Ended
H. But There is Progress Toward Stronger Markets

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A. Confusing Time 

This is a confusing time in the markets. A recent headline declared the end of the declines in the stock market…

“The bear market in stocks has officially ended and a new bull market has kicked off. Here's why investors can expect more gains ahead.” (LINK) 

        By Matthew Fox Fri, June 9, 2023 at 3:13 PM PDT·

The longest bear market since 1948 is officially over after the S&P 500 closed above 4,292 on Thursday, representing a 20% rally from its October 12 closing low of 3,577.

The threshold was reached on the back of better-than-feared corporate earnings, a resilient economy and job market, and the expectation that the Federal Reserve is about to pause its aggressive cycle of hiking interest rates.

Yet not all parts of the stock market have received the news. While the tech-biased NASDAQ stock index is moving higher quickly (likely sparked by the AI theme) with year-to-date performance through last Friday (June 9) of 33%, the DJIA has lagged. It has had a return of 3% over the same period. The technology sector of the economy and stock market is currently a breakaway sector. I explain why the DJIA and NASDAQ have had such different performance and why we should be okay with this difference, even if it is painful.

But the key points for you as an investor are:

• Be patient with recent performance - it has been lackluster this year for most of the stock market.
• Do not switch portfolios to try to get higher returns
• The difference between top performing ETFs (leading) and bottom performing ETFs (lagging) is large by historical standards in normal times. If one chases performance and switches to a portfolio or ETF that has recently been leading one runs the risk of selling ETFs that will be lead in the future and buying ETFs that will lag.
• Be cautious of what the business press says. Many have said the bear market is over. It seems to be over for the tech sector and the NASDAQ, but it not quite over for the rest of the economy and stock market outside of technology. 

B. This Type of Divergence is Expected and Why We Focus on the DJIA

This type of situation is exactly why we focus our portfolio on the DJIA and not on what we in the investment industry call “market-capitalization weighted” indexes, such as the Russell 1000 (consisting of 1000 companies) and the S&P 500 (consisting of 500 companies). These market capitalization-weighted indexes seek to invest in all major companies in an economy and in all its economic sectors (Energy, Consumer Staples, Utilities, Technology, etc.). The weight of each company in the index is determined by price of its stock and the number of stock shares it has in the marketplace. The higher the price goes the more weight it is given in the index. These indexes have advantages if you are investing billions of dollars.

This type of index also works fine for individual investors when stock price appreciation is spread evenly across all economic sectors, but it can cause trouble when one sector experiences abnormally high price gains; when it becomes a breakaway sector. If the companies in one sector do better than companies in other sectors, that sector is weighted more heavily in the index.

Two sectors that have tended to be breakaway sectors in the past are technology and energy. The technology sector became a breakaway sector in the late 1990s with the Internet/Dotcom boom. Energy was a break away sector in the 1970s and 1980s.

As the breakaway the sector did better it got a higher weight in broad stock market indexes such as the S&P500.  And it got to its highest weight in the index at the very peak of its performance cycle. 

This happened to the tech sector in early 2000, just before the technology bubble collapsed. As individual investors, we do not want that. We would like to have less weight in a breakaway sector at the peak of its performance cycle.

In contrast, the DJIA focuses on 30 companies and does not seek to have full representation of every sector in the economy. The weights of individual companies and sector weights do not change as dramatically over time as they do in market-capitalization weighted indexes. This is because it selects just a few high-quality companies for inclusion and uses an archaic weighting scheme. The result is greater consistency in the weighting of the 30 companies. The net effect is that it is less prone to give the highest weight to an individual company or a sector at the top of its performance cycle. 

The link to our ETF holdings page (https://marketresilience.blogspot.com/p/etf-holdings.html) shows the weight of stocks in the DJIA and NASDAQ-100.  You can see that the largest holdings in the DJIA are smaller than the largest holdings in the NASDAQ – a market-capitalization weighted index. That means the DJIA is less concentrated in a few specific companies. 

In our early research on stock indexes, we found that the DJIA gives more reliable signals indicating its future direction than do the S&P500 or Russell 1000. We believe the small number of high-quality companies it holds (30) and its archaic weighting scheme contribute to its reliability. Thus, in addition to the advantage of its long history, we found its signal reliability very attractive, and the DJIA is our core stock index.

We also find it is better to make decisions about the technology and energy sectors of the stock market separately from the rest of the economy; they follow their own independent cycles and series of inflection points. 

At this time, technology is a breakaway sector. NASDAQ has a roughly 58% weight in companies in the technology sector, with the S&P500 having 28% in tech. The DJIA has an 18% weight in the sector. While the NASDAQ and to an extent the S&P500 rocket higher with tech, the DJIA and other sectors are still on the ground. The other sectors of the economy are is contending with concerns about slower growth brought on by higher interest rates, inflation, and a possible recession. 

The impact of tech on the S&P is discussed in an article I've posted over the last few weeks: https://www.axios.com/2023/06/01/sp500-tech-companies-stock-price.

The strength of the current stock market in the technology sector may be influenced by the hype about ChatGPT and AI. Should they fail to live up to the hype (which is likely) the tech sector may experience a meaningful decline. It could then drag down the indexes, such as the NASDAQ and S&P500, that have high weights in the tech sector. We may find that the press article I mentioned at the beginning of this post is not as strong as it currently seems.   

C. The Spread Between Leading and Lagging Sectors is High

Our stock ETFs tend to have low exposure to technology and have lagged the technology sector. The conservative stock ETFs of XLP (consumer staples companies) and XLU (utility companies) have performed poorly.  These lagging indexes are fighting the battles with inflation and a possible recession (although the threat seems to be receding).

The important concept right now is that the spread between leading and lagging indexes/ETFs is high by recent standards. Figure 1 below shows the monthly returns of the stock ETFs we hold. The cluster at the far right in the ellipse shows the returns for May 2023.

• DJIA:             -3% in May 2023
• Cons Staples: -6%
• Utilities:          -6%
• NASDAQ:          8%

Figure 1

Over the 18 months shown above, all indexes/ETFs had positive returns in half the months except Consumer Staples (XLP), which had slightly fewer (8 out of the 18 months were positive). 

The turquoise bar in Figure 1 above indicates the difference, or spread, between the top, “Max,” performing index (NASDAQ at 8%) and the bottom, “Min,” performing (Consumer Staples at -6%) for May, which is 14 percentage points.  Over the months shown in Figure 1, we can see that the level of 14% is the second highest of the period. In March of 2022, the difference was 16%. Over the 18-month period shown, NASDAQ, shown as the purple bar, is sometimes very positive and sometimes very negative, which reflects the boom-and-bust pattern we see in technology stocks. 

For clarity, Figure 2 below shows only the Max-Min line over the same period. It shows 14% for May.

Figure 2

You can see more clearly that the recent spread between the top and bottom performing ETF in May was indeed among the highest. 

Figure 3 below shows the monthly Max-Min line over a longer timeframe, going back to January of 1990.  A key point is that the current high level of about 15% is quite high by historical standards except for the Internet boom and bust that ran from about 1997 to 2003.  

Figure 3

From this perspective, the current outperformance of NASDAQ may be at the extreme and it may be reversed over the near future. To invest heavily in NASDAQ now may risk investing in it just as it begins to underperform the others. The Micro MRI for the NASDAQ was at the 87^th percentile last Friday - a high level. Thus, we will move into NASDAQ opportunistically. 

There have been several periods over the last 100+ years in which there have been large spreads between the DJIA and breakaway sectors such as technology and energy. Even considering these periods, the historical simulations indicate that our strategy can produce high return and low variability.  

D. Not Yet a Bull Market for the DJIA

Figure 4 below indicates the status of the Macro MRI for key indexes. This first column indicates whether the Macro MRI is now in the upleg of its cycle. The second indicates the Macro’s level (percentile) compared to its own history. Third, whether the Exceptional Macro is present. Fourth, whether the index could be described as being in a bull market as indicated by the Macro MRI being in the upleg of its cycle and the presence of the Exceptional Macro. The inception date of the index.

Figure 4

Historically, bull markets are most reliably indicated by the DJIA. Thus, that the DJIA has not made a full shift is worth noting. It is best to follow our discipline which is to pay most attention to the DJIA, which suggest caution at this time. 

The current status is somewhat troubling because the physics-based drivers we’ve recently developed indicate that the Macro MRI had an opportunity to begin its upleg last September. The NASDAQ seems to have responded to that driver, but the DJIA has not.

For the DJIA, the beginning of the Macro’s upleg was late and the Exceptional Macro made sporadic appearances, which is not at all typical. Looking back over the last 100 years, the Macro MRI has been more responsive to the driver. We suspect that the lack of major declines in stocks over the last 18 months has allowed high stock valuations to persist, and that this is a major factor in the lackluster stock returns outside of the tech sector. The DJIA seems to suggest there is unfinished business from the last year and a half.  

E. High Stock Valuations

Figure 5 below shows that the current valuations levels are still high for the DJIA. When valuations are high, stock prices tend to move lower. When valuations are low, stock prices tend to move higher. This is a version of buy low and sell high.

The important Price/Book and Price/Sales ratios for the DJIA are still high by historical standards, at the 83^rd and 88^th percentile, respectively. This is a high level compared to the historical refence points (A, B, and C) shown that are the low points of the DJIA price levels (after large declines), just before a bull market begins.  

Figure 5

It appears that investors in general have not been concerned by these high levels. The same is true for companies in NASDAQ. Figure 6 below shows the same table for the NASDAQ 100. 

Figure 6

The important Price/Book and Price/Sales ratios are still high by historical standards, at the 91^rd percentiles for both. This is a high level compared to the historical refence points (A, B, C, and D) shown that are the low points of the NASDAQ price levels (after large declines) just as a bull market begins. 

F. Corporate Earnings Have Not Yet Declined

By some measures, corporate earnings have not yet shown the declines that might be expected after a bear market. Figure 7 below shows the DJIA (brown line, log scale) and our measure of “Economic Load” (orange) on the stock market. Economic Load is our composite of valuation statistics, change in short-term interest rates, and a comparison of stock dividend yield to bond yields.  The higher the orange line, the more downward pressure there is on stock prices and corporate earnings (double blue line).  

Figure 7

After the major peaks in the economic load in 2007 (C) during the Global Financial Crisis, the DJIA and corporate earnings declined meaningfully. The same is true after B although that decline was affected by the COVID pandemic. It appears that the current situation (A) is different. The anticipated declines have not yet occurred. Perhaps they won’t, but it is too early to conclude they won’t because the declines in stock prices and corporate earnings occurred well after the peaks of the economic load at C and B. 

G. A Period of Low Investor Excitability Has Just Ended

This lack of concern about valuations economic load could be related to the period of low investor excitability we have just passed through. At the beginning of 2022, we indicated that the next several months could be expected to have muted price cycles – an indication that investors will not get excited about either good news or bad news. This view is based on our recent research on the drivers of resilience. That same research suggests that the calm is over and that investors will now be much more excited about both good news and bad news. We may find that investors will now be more concerned about valuations and favor lower prices for stocks. If true, the reliability and the current conservative nature of the DJIA will be to our advantage. 

H. But There is Progress Toward Stronger Markets

I do think we have begun a new long-term trend toward higher stock prices. The stock market has been battling headwinds since the end of 2017, and this has been a very challenging period.  But that period appears to be over. The Macro MRI for most all stock indexes are at low levels and moving higher.  There will still be challenges but instead of headwinds fighting our progress, we are likely to have tailwinds the help us along as we work through the short-term challenges presented by the markets. 

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